integrated financial managementmay 15 financial modeling
TRANSCRIPT
Integrated Financial Management Apr 21, 2023
Financial Modeling
Financial Modelling Apr 21, 20232
Valuation, Decision Making and Risk
Every major decision a company makes is in one way or another derived from how much the outcome of the decision is worth. It is widely recognized that valuation is the single financial analytical skill that managers must master.
• Valuation analysis involves assessing
Future cash flow levels, (cash flow is reality) and
Risks in valuing those cash flows, whether it be the cash flow from assets, debt or equity
• Measurement value – forecasting and risk assessment -- is a very complex and difficult problem.
Reference: Chapter 4
Financial Modelling Apr 21, 20233
Teaching Objectives of Model Construction
• The best and perhaps the only real way to learn modeling is under the tense pressure of a real transaction – when a model must be created and audited under a tight deadline.
• Notwithstanding this, the exercises and lecturers are intended to provide:
A head start for those who have not created models and will have to learn the hard way.
Helpful ideas to experienced model builders in designing and structuring more efficient, stable, transparent and accurate models.
• The discussion covers how to build a well structured financial model that clearly delineates inputs, effectively presents key value drivers, uses separate modules to organize various components, accurately computes cash flow that is available to different debt and equity investors, and presents results of the analysis that accurately display risks of the investment.
Financial Modelling Apr 21, 20234
Financial Modelling Outline
Developing the structure and layout of alternative types of models
Notes on model structure, programming practices and model periods
Organizing time periods in a model
Value drivers and model inputs
Debt modules -- sweeps, traps, defaults and debt IRR
Fixed asset modules and depreciation and amortization
Income statement and tax schedule
Cash flow and waterfall
Balance sheet and other auditing tools
Presenting key valuation outputs of a model
Performing sensitivity and scenario analysis on model outputs
Integrated Financial Management Apr 21, 2023
Model Objectives
Financial Modelling Apr 21, 20236
Measurement of Risk in Financial Models
• The fundamental issue in any valuation problem is how to assess the risk of future cash flow projections.
Financial theory
Financial theory dictates that the CAPM should be used to compute the WACC, that the un-levered beta should be used to estimate equity returns, that options pricing models should be used for credit spreads, debt capacity and covenants.
Mathematical Models
Mathematical models include beta adjustments for the CAPM, statistical models for credit analysis, Monte Carlo simulation and value at risk.
Practical Market Information
Practical market information can be used to gauge required equity returns, required credit spreads, required financial ratios to achieve investment grade rating and other issues.
Direct Evaluation with Financial Models
Use of financial models to directly assess risks through sensitivity, scenario and simulation analysis.
• Consider Investment Alternatives A and B, where A has a higher project IRR than B. Assume A has a return of 11% and B has a return of 9%.
• Project A or Project B would be selected through assessing the return on the projects relative to the weighted average cost of capital for each project. If the WACC for A is 10% and for B is 9.5% then A is selected. One must computed beta for each investment.
• Compute the distributions in cash flow of project A and project B to equity holders. If the standard deviation is lower for project B, then assess the risk relative to the return.
• Compute the achieved rate of return from the ability to raise debt and then assess the return earned on equity. If the return on equity is greater for B then A, select project A.
• Use judgments with respect to different variables to evaluate different scenarios.
Financial Modelling Apr 21, 20237
A Financial Model is a Statistical Tool
• In developing a financial model, the basic thing you are doing is summarizing a complex set of technical and economic factors into a number (such as value per share, IRR or debt service coverage).
Forecasting has become an essential tool for any business and it is central to statistics -- in assessing value, credit analysis, corporate strategy and other business functions, you must use some sort of forecast.
Some believe economic forecasting has limited effectiveness and worse, is fundamentally dishonest because uncertain unanticipated events such as the internet growth, high oil prices, sub-prime crisis, falling dollar continually occur.
The whole idea of modeling, like statistics, is quantification. If a concept cannot be quantified, it is a philosophy. The fundamental notion of statistics is presenting and summarizing information, this is the same as a financial.
Financial Modelling Apr 21, 20238
Danger of Believing too Much in Models
• Alan Greenspan, Financial Times.
“The essential problem is that our models – both risk models and econometric models – as complex as they have become – are still too simple to capture the full array of governing variables that drive global economic reality. A model, of necessity, is an abstraction from the full detail of the real world.”
• Nicholas Taleb:
In the not too distant past, say the pre-computer days, projections remained vague and qualitative, one had to make a mental effort to keep track of them, and it was a strain to push scenarios into the future. It took pencils, erasers, reams of paper, and huge wastebaskets to engage in the activity. The activity of projecting, in short, was effortful, undesirable, and marred with self doubt.
But things changed with the intrusion of the spreadsheet. When you put an Excel spreadsheet into computer literate hands, you get projections effortlessly extending ad infinitum. We have become excessively bureaucratic planners thanks to these potent computer programs given to those who are incapable of handling their knowledge.
Financial Modelling Apr 21, 20239
Financial Models
• A good financial model should:
Be relatively simple
Focus on key cash flow drivers
Clearly convey assumptions and conclusions
Evaluate Risks through sensitivity analysis, break-even analysis, scenario analysis
• Alternative Models
Back of the Envelope
Check Overall Return on Model
Check EV Relative to Cost of New Assets
Deterministic
Set a number of assumptions and translate into financial ratios and cash flow
Stochastic
Develop a range of possible inputs using Monte Carlo simulation. Used where there is a good and predictable history for value drivers.
This is not easy but very important
Financial Modelling Apr 21, 202310
Example of Outputs From a Participant
• This is an example of an completed output
Integrated Financial Management Apr 21, 2023
Layout and Structure of Alternative Types of Financial Models
A good model allows decision makers to focus on appropriate risks and summarizes data in an efficient way –
the key valuation issues should pop out at you
Financial Modelling Apr 21, 202312
Four Different Model Types -- Corporate Models, Project Finance Models, Acquisition Models And Merger Integration Models
• Corporate model
A corporation has a history and it is assumed to last indefinitely (although they probably won’t in reality.) This means that valuation of a corporation begins with historic analysis and the models must include some kind of terminal value assumption because the cash flows are not projected forever.
• Project finance model
The investment is characterized by different phases and the fact that there is no history (no matter how many times a similar new combined cycle plant is built, you don’t know how it will work until you switch it on.) The project finance models focus on cash flows and generally cover the entire defined lifetime of the project.
• Leveraged buyout model
The transaction is defined by an entry price, the holding period and exit price and the manner in which the acquisition is financed. Leveraged buyout models define manner in which alternative financing sources are repaid and compute the return earned by equity investors.
• Integrated consolidation model
Computes earnings per share and other financial ratios before and after an acquisition. This type of model considers the specific financing and accounting of the transaction as well as cost savings generated by the transaction.
Financial Modelling Apr 21, 202313
Structure of Alternative Models
CorporateModel
ProjectFinance
LBOModel
M&A Integration Model
Valuation from Model
Present Value of Discounted Free Cash
Flow or Multiples
Investment Decision and Implied Value depends on Equity IRR versus Market
Hurdle Rate
Entry Multiple and Acquisition Premium Depends on Equity
IRR and Hurdle Rate
Acquisition Premium Depends on Earnings
per Share Acretion and Debt Ratios
Base Case Risk Measurement
Weighted Average Cost of Capital,
Multiples, Terminal Growth
Debt Capacity, Debt Terms
Senior and Subordianted Debt Financing and Exit
Multiple
Sources of Funds Used for Tranasction and Assessment of
Credit Quality
Traditional Risk Assessment from Equity Perspective
Sensitivity Analysis and Scenario Analysis of DCF and Multiple
Value
Sensitivity Analysis and Scenario Analysis
of Equity IRR
Sensitivity Analysis and Scenario Analysis
of Equity IRR
Sensitivity Analysis and Scenario Analysis of EPS Accrection and
Credit Quality
Traditional Risk Assessment from Debt Perspective
Break-even Analysis to Determine Ability to
Re-finance and Maintain Credit Rating
Break-even Analysis to Determine at what
Point Cash Flow Cannot Service Debt
Break-even Analysis to Determine IRR on
Senior and Subordinated Debt
Break-even Analysis to Determine
Prospective Credit Rating
Monte Carlo Analysis with Model
Probability Distribution of EPS and DCF
Valuation
Probability Distribution of Equity IRR and
Probability of DSCR below 1.0
Probability Distribution of Equity IRR, Senior IRR and Junior IRR
Valuation Analysis in Alterative types of Models
Financial Modelling Apr 21, 202314
Alternative Types of Models
ProjectFinance
CorporateModel
LBOModel
M&A Integration Model
Information Base
Contracts and analysis of
Commodity Prices and other value drivers
Historical financialstatements; Analysis
of value drivers
Historical financialstatements; Analysis
of value drivers; Transaciton Terms
Historical financialstatements; Analysis
of value drivers; Transaciton Terms
Model Starting Point
Sources and Uses Analysis
Historic Balance SheetSources and Uses and
Pro-Forma Balance Sheet
Sources and Uses and Pro-Forma Balance
Sheet
Cash Flow Process
Cash flow waterfall that ultimately
measures dividends paid to equity
Net cash flow after dividends that result in changes in short-term debt or surplus cash
Cash flow waterfall that ends in dividends
paid to equity
Cash flow changes that result in changes in short-term debt or
surplus cash
Debt AnalysisNew Debt Issues from
TransactionNew and Existing
New Debt Issues from Transaction
Existing Debt Issues; Retired Debt Issues;
New Debt Issues
Model Termination End of project lifeArbitrary terminal
periodTransaction holding
periodEPS analysis period
Model Complexities
NOL; cash traps and sweeps; construction period issues; debt
service reserves; debt sculpting
NOL; target capital structures; circularity; depreication vintage
NOL; cash sweeps; interest capitalization
on sub debt; debt service reserves; terminal period
Pro-forma balance sheet; minority interest
changes; new debt issues
Model OutputEquity IRR; Project
IRR; DSCR
DCF Valuation; EPS projection; Implied P/E; Credit Quality
Equity and Debt IRRs; Debt/EBITDA
Project EPS and Other Ratios on Standalone vs Combined Basis
Structure of Alternative Models
Financial Modelling Apr 21, 202315
Credit Analysis – Combination of Historic Financial Ratios and Modeling in Establishing Credit Ratings
• Financial Model Outputs for Very Low Credit Risk (AA)
Growth and low leverage, positive cash generation, consistent dividend payments – in a downside case, the company should still be able to pay dividends and have good financial ratios.
• Financial Model Outputs for Low Credit Risk (A)
Similar to above, except that debt leverage can be moderately increasing due to acquisitions and capital expenditures.
Access to debt markets as evidenced by financial ratios
• Financial Model Outputs for Moderate Risk (BBB)
Strong capacity to service debt in next three years
Modest dividend payments, ability to survive next business cycle – in a downside case, the company should be able to pay back debt and reduce leverage if dividends are cut.
• Financial Model Outputs for High Risk (BB)
Tight but positive debt service coverage in two years
Cash flow volatility and high leverage; little discretionary cash flow – in a downside case leverage increases and the company has weak financial ratios
• Financial Model for Very High Risk (B)
May have to cut costs to maintain debt service
No dividend payments; highly leveraged capital structure
Integrated Financial Management Apr 21, 2023
Architecture of Alternative Models
Financial Modelling Apr 21, 202317
Sheet Ordering and Layout – Corporate Model
• Base Historic Financial Data
Balance Sheet as Anchor
• Input Sheets
Different colors
Arranging of inputs
Set-up Sensitivity
• Working Sheets
Arrangements by revenues, expenses, capital expenditures and working capital
Arrangements by capacity, demand, and cost structure
• Working Capital Analysis
• Depreciation Schedule (Book and Tax)
Vintage of asset classes and Tax Depreciation
• Debt Schedule
Issue by issue and sum the totals
• Financial Statements
Income Statement
Tax Calculation
Cash Flow
Balance Sheet
• Output Sheets
Valuation (Market data on Beta etc)
Financial Ratios
Financial Modelling Apr 21, 202318
Structure of a Standard Corporate Model
Revenue, Expense andCapital Expenditure Analysis
Working Capital Analysis
Debt Schedule ofExisting Issues
Fixed Asset ScheduleBook and Tax Depreciation
Inputs:
HistoricFinancials
Operating Drivers,
Financing,
Tax
Initial BalanceSheet
Profit and LossFixed Interest
Changing Interest
Taxes Paid, TaxesPaid and Taxes Deferred
Cash Flow Statement
Cash Balance, Debt Balance
Surplus Cash BalanceEquity Balance
BalanceSheet
FreeCashFlow
Financial Modelling Apr 21, 202319
Working Sheet –Revenues,
Expenses,
Cap Exp, WC
Depreciation
Beginning
Balance Sheet
&
Financial
StatementsOutputs –
Value
Credit
Quality
Historical
Financials
Existing
Debt
Free Cash
Flow
Inputs
Components of a Corporate Model – Historic Financial Data, Debt Structure, Working Sheet, Financial Statements and Free Cash Flow
Financial Modelling Apr 21, 202320
Basic Model Logic of Standard Corporate Model
• The basic logic in a financial model is simply determining what happens to cash flow.
• Something must be done with the deficient or surplus cash flow – retiring or issuing debt, issuing or retiring equity etc.
• The model must account for operations as well as the financial structure of the company (the financial structure is primarily the existing debt of the company)
• The model should compute free cash flow, earnings and other financial ratios for valuation
• Focus of the model should be on value drivers and development of assumptions
Financial Modelling Apr 21, 202321
Cash Flow Process of a Corporate Model
Income StatementEBIT, Taxes, etc. Fixed Interest Short-term Interest Interest IncomeNet Income
Analysis of Fixed Debt Issues Fixed Interest Expense Debt Maturities New Issues Debt Balance Cash Flow
StatementNet Income, Depreciation etc. Debt MaturitiesNet Cash Flow
Balance SheetSurplus Cash PlugOther Assets.
Short-term DebtFixed DebtOther LiabilitiesCommon Equity
Net Cash AnalysisNet Cash (Cash – Short-term Debt) Beginning Balance Add: Cash Flow Ending Balance
If Ending Balance > 0, CashIf Ending Balance < 0, Std
Interest Income = Cash x RateInterest Expense = STD x Rate
Financial Modelling Apr 21, 202322
Sheet Layout – Project Model
• Plant cot contracts and market drivers
• Input Sheets
Different colors
Arranging of inputs
• Working Sheets
Arrangements by revenues, expenses and capital expenditures
Arrangements by capacity, demand, and cost structure
• Uses and Sources of Funds (Monthly Construction Expenditures)
Conversion from Annual
Computation of Interest During Construction
• Debt Schedule (Sources of Funds)
• Depreciation Schedule
• Financial Statements
Source and Use of Funds
Income Statement
Balance Sheet
Cash Flow -- Waterfall
• Output Sheets
Valuation - IRR
Debt Service Coverage Ratios
Financial Modelling Apr 21, 202323
Inputs
Operating- Capital Expenditures- Revenues- Operating Expenses- A/R and A/P
Financial and Tax- Debt Leverage- Interest Rate- Debt Repayment- Tax Rate- Tax Depreciation
Mechanics
Construction Sources & Uses
Income Statement
Cash Flow Statement
Balance Sheet
Equity Cash Flow
Project Free Cash Flow
Outputs
IRR – EquityIRR – ProjectNet Present ValueReturn on InvestmentEconomic ProfitDebt Service CoverageLLCRPayback PeriodAccounting Earnings
Basic Project Finance Model Components
In a project finance model, the dividends = cash flow
Financial Modelling Apr 21, 202324
Structure of a Project Finance Model
Revenue, Expense andCapital Expenditure Analysis
Working Capital AnalysisInputs:
Operating Drivers from
Contractsand Other,
EPC Contract,S-Curve,
Interest Rate
Tax
Profit and Loss
Taxes Paid, TaxesPaid and Taxes Deferred
Cash Flow Statement With Waterfall,Debt Defaults,Sweeps etc.
Cash Balance, Debt BalanceEquity Balance
BalanceSheet
Equity IRRDSCR, LLCR
Sources andUses of Funds
DuringConstruction
IncludingInterestRoll-up
DebtSchedule
FixedAssetsInterest
CapitalizedFees and
Other
Financial Modelling Apr 21, 202325
Project Model versus LBO Acquisition Model
• No detailed capital expenditure budget by months and interest during construction
• Modeling of terminal value and debt outstanding remaining explicit forecast period that is covered by the terminal value
• Development of pro-forma balance sheet to begin the model from the sources and uses statement
• Cash flow to debt ratios and valuation ratios to establish terminal value
Financial Modelling Apr 21, 202326
Model Sheets in Project Finance Model
Inputs – Prices, Costs, Capacity,
Technical Parameters
Working Sheet toDerive Revenues Expenses
and Working Capital
Annual Financials –Income Statement, Cash Flow –
CASH WATERFALL
and Balance Sheet
Outputs – Free Cash Flow,
Equity Cash Flow
Value (IRR), DSCR
Debt Schedule –Debt Balance From
Drawdown Debt Balance,
Interest Expense
Source and
Use of Funds – Draw down, IDC, Equity Issues
and Capital Expenditures
Depreciation –Depreciation Expense
Plant Balance
Financial Modelling Apr 21, 202327
LBO Model Structure
• Model Structure is Essential in Modelling Acquisition
Begin with history and drivers as in corporate model
Work through acquisition transaction and compute
Purchase Price
Consideration
Sources and Uses of Cash
Transaction Multiples
Goodwill
Pro Forma Balance Sheet
Terminal Proceeds and Exit Multiple
Compute debt schedule from the uses and sources of funds
Profit and loss statement is relatively simple
Cash flow statement has waterfall
Financial Modelling Apr 21, 202328
Sheet Layout – LBO Model
• Purchase price premium, operating cash flows, terminal value
• Input Sheets
Different colors
Arranging of inputs
• Working Sheets
Arrangements by revenues, expenses and capital expenditures
Arrangements by capacity, demand, and cost structure
• Uses and Sources of Funds (Monthly Construction Expenditures)
Conversion from Annual
Computation of Interest During Construction
• Debt Schedule (Sources of Funds)
• Depreciation Schedule – Include asset write-up and amortisation of intangibles
• Financial Statements
Source and Use of Funds
Income Statement
Balance Sheet
Cash Flow -- Waterfall
• Output Sheets
Transaction Multiples
Valuation - IRR
EV/EBITDA and Debt to EBITDA
Financial Modelling Apr 21, 202329
Model Sheets in Leveraged Buyout Acquisition Model
Inputs – Purchase Price,
EBITDA, Terminal Value
Working Sheet toDerive Revenues Expenses
and Working Capital
Annual Financials –Income Statement, Cash Flow –
CASH WATERFALL
and Balance Sheet
Outputs – Free Cash Flow,
Equity Cash Flow
Value (IRR),
Debt./EBITDA
Debt Schedule –Debt Balance From
Drawdown Debt Balance,
Interest Expense
Source and
Use of Funds – Purchase Price
and Capital Structure
Depreciation –Depreciation Expense
Plant Balance
Financial Modelling Apr 21, 202330
Structure of an Acquisition Model
Revenue, Expense andCapital Expenditure Analysis
Working Capital Analysis
Inputs:
Operating Drivers from
History,
AcquisitionPrice andFinancingSources,
Tax
Goodwill andPurchase Price
Allocation
Profit and Loss
Taxes Paid, TaxesPaid and Taxes Deferred
Cash Flow Statement With Waterfall,Debt Defaults,Sweeps etc.
Cash Balance, Debt BalanceEquity Balance
BalanceSheet
Equity IRRDebt IRR
Sources andUses of Funds
Pro-FormaBalanceSheet
DebtSchedule
FixedAssets
Fees andOther
Financial Modelling Apr 21, 202331
M&A Integration Model
• Inputs for transaction
Consolidated tax rate, interest rate on new financing, dividend payout ratio, other financing parameters on consolidated basis
Synergies
Transaction assumptions (transaction price, debt retirement, new debt financing)
• Sources and Uses of Funds
• Goodwill
• Pro-forma Balance Sheet Including Shares
• Target Financials
• Buyer Financials
• Debt Issues
• Depreciation and Tax Adjustments
• Consolidated Financials
• Outputs
Financial Modelling Apr 21, 202332
Structure of an Integrated Consolidation Model
Target Company Financials
Acquiring Company Financials
Inputs:
Operating Drivers from
History,
AcquisitionPrice andFinancingSources,
Tax
Goodwill andPurchase Price
Allocation
Profit and Loss
Taxes Paid, TaxesPaid and Taxes Deferred
Cash Flow Statement
Cash Balance, Debt BalanceEquity Balance
BalanceSheet
EPS AccretionCredit Measures
Sources andUses of Funds
Pro-FormaBalanceSheet
DebtSchedule
FixedAssets
Fees andOther
Financial Modelling Apr 21, 202333
Sheets in M&A Consolidation
Target
FinancialsConsolidated
Financial
Statements
Outputs –
Value
Credit
Quality
Transaction &
Source and Use
AnalysisAcquirer
Financials
Goodwill &
Pro-Forma
Balance Sheet
Debt Issues
Including Debt
For Financing
Financial Modelling Apr 21, 202334
Computation of Consolidation in Model versus Standalone Model
• The basic principle in consolidation include:
The starting point is the pro-forma balance sheet instead of a base historic balance sheet
For free cash flow items (EBITDA, Cap Exp, Deferred Tax, Working Capital) -- Use the data from the individual model runs.
For fixed debt items, use the aggregation of the debt issues as with normal corporate models
For new financing, dividends, taxes and equity issues compute the amounts for the new model.
Financial Modelling Apr 21, 202335
Common Features in All Models
• Models require a starting point
Corporate model – balance sheet
Project finance and LBO – sources and uses
Merger model – sources and uses and pro-forma balance sheet
• Keep free cash flow assumptions separate from financing assumptions in a working sheet
• Keep a separate page for existing debt facilities
Integrated Financial Management Apr 21, 2023
Notes on Good Modelling Practices
Financial Modelling Apr 21, 202337
Best Practices and Good Practices
• It is dangerous to become obsessed with best practices in modelling
You can become bureaucratic and waste time
There are almost always exceptions to best practices
Example
Keep formulas the same, even in base year
Use range names in all cells
Ernst and Young: Rarely use range names
• It is much easier to define bad practice
Long formulas are the worst single problem
Keep inputs together and logical
Financial Modelling Apr 21, 202338
Good Modelling Practise
1. Divide the model into separate modules, beginning with an input section.
2. Compute how the value drivers determine operating revenues, operating expenses and capital expenditures in a separate “working” module rather than in financial statements.
3. Understand the starting point of the model as it relates to the valuation issue (balance sheet, sources and uses statement or both).
4. Carefully define the time period of the model using codes that define alternative phases of the analysis.
5. Work through every single balance sheet item showing the opening balance, changes and the closing balance for each the accounts. This analysis should be made for everything ranging from cash accounts to common equity.
6. Include separate modules for debt issues, fixed plant assets, working capital and cash balances.
Financial Modelling Apr 21, 202339
Good Modelling Practise
7. Limit or avoid the use of macros and iterations to resolve circular references as circular references are not present in the real world.
8. Use the balance sheet as an auditing tool and include a separate “integrity” page of model verification checks.
9. Assure that no formulas in the output module of a model affect anything in any other section of the model.
10. Make sure that spreadsheet columns are consistent throughout the model and that the formulas for each column are identical (at least for the forecast period).
11. Include a “dashboard” at the top of each page of the model to monitor the integrity and key outputs of the model.
12. Keep formulas in the model as simple as possible and clearly delineate how each formula is derived from the inputs.
13. Use the positive number convention which holds individual elements as positive numbers and performs additions or subtractions in the subtotal items.
Financial Modelling Apr 21, 202340
Simple Formulas
• The modeling practices are discussed in another sheet named spreadsheet conventions.
• The most important is keeping the formulas simple and making the sheets transparent and easy to read.
• The following should be in many other lines.
Financial Modelling Apr 21, 202341
Balance Sheet as Anchor and Cork-screws
• Use the last historic balance sheet to anchor many accounts. In each case, the closing balance in the last historic year should come from the balance sheet.
• It is good practice to have accounts for all balance sheet items
• Some examples include:
The plant balance
The debt balance
Net “cash bucket” balance
The NOL balance
The Un-amortised debt fee balance
The basis for changes in working capital
Common and preferred equity
Financial Modelling Apr 21, 202342
Corkscrews - Continued
• For each account that is modeled, the closing balance of the account should come from the final balance sheet.
• For example:
Plant balance
Closing balance the amount of gross plant in the base year (the final year before the start of the model)
• In the case of debt
The sum of the closing balance that anchor the debt facilities should sum to the amount on the balance sheet.
You should include a verification check to make sure that the individual accounts tie to the balance sheet.
Financial Modelling Apr 21, 202343
Sheet and Color Format
• Use small columns and then large column
• Show units in a column
• Use colors to show the sheet derivation
Integrated Financial Management Apr 21, 2023
Time Period Definitions in Models
Financial Modelling Apr 21, 202345
Switches in Alternative Models
• Switches for time periods in alternative models
General Corporate Models
Switch for History versus Forecast
Switch for Terminal Period
Project Finance Models
Switch for Development Period
Switch for Construction Period
Switch for Operation Period
Switch for Debt Repayment Period
Leveraged Buyout Models
Switch for Transaction Period
Switch for Holding Period
Switch for Terminal Period
Financial Modelling Apr 21, 202346
Dates and Length of Period
• Standard IRR and NPV calculations in Excel assume that the cash flows occur at the end of the period
• To be consistent with this, one would make the formulas for interest, depreciation and other items use the opening balance rather than the average or the ending balance
• To be careful, explicitly show the beginning day of the period and the ending day of the period and use XIRR and XNPV
• Explicitly show how many month are in each period
Financial Modelling Apr 21, 202347
Length of a Corporate Model
• Explicit forecast period should in theory be long enough for a company to reach a steady-state.
• Of course, nobody really knows when this steady state will occur.
• In a steady-state:
Company grows at a constant rate
Capital expenditures are a constant proportion of operating profits
Company earns a a constant rate of return on new investments
• Copeland recommends a forecast period of 10-15 years
• In theory the length of the forecast should only affect the distribution between continuing value and the explicit forecast value, but this never really happens
Integrated Financial Management Apr 21, 2023
Modelling Value Drivers
Financial Modelling Apr 21, 202349
Inputs, Drivers and Working Analysis
• Setting-up Sensitivity Analysis
• Creating Indices
• Working Capital Modelling
• Comparison with Historic Data and Other Metrics
• Dash Board
Financial Modelling Apr 21, 202350
Real World Modelling Process – Corporate Models
• The following six step process
• Step 1: Gather Historic Financial Statements and read them (it is not so bad)
• Step 2: Change the Arrangement of Financial Statements (See the example on the subsequent slides)
• Step 3: Compute Ratios from Historic Financial Statements to develop some of the mechanical assumptions such as A/R to sales and depreciation rate
• Step 4: Develop Revenue, Expense and Capital Expenditures by Working through Value Drivers
• Step 5: Work through the Income Statement, then the Cash Flow Statement, then the Balance Sheet to Check, only for forecast years
• Step 6: Valuation, sensitivity analysis and presentation
Financial Modelling Apr 21, 202351
• Translate value drivers such as price, the cost of new capacity and cost structure to financial statement projections
• You often need minimal operating data – one measure of capacity and one measure of sales
• Evaluate historical relationship between value drivers and financial variables
There is no generic formula for establishing value drivers
Value drivers should incorporate some kind of capacity, capacity utilization and cost structure assumptions
• Determine how the financial structure – the outstanding debt – affects financial performance
Use of History to Determine Drivers in Corporate Modeling
Financial Modelling Apr 21, 202352
Results of Arranging Inputs
• When you are finished arranging items:
You should have an opening balance sheet
Total non-cash current assets
Total non-debt current liabilities
Total fixed debt to be repaid
You should have a debt schedule
Aggregate of debt issues should tie to balance sheet
You should have a history of revenues, expenses and depreciation
Use revenues and expenses and focus on drivers
Use depreciation to determine the deprecation rate
Financial Modelling Apr 21, 202353
Input Sheet Suggestions
• Set-up combo boxes and scenarios early-on
Use a part of the sheet for settings and combo box inputs
Use range names
• Set-up inputs to re-set base case inputs so you don’t lose them in scenario or sensitivity analysis
• Use data validation for non-numeric inputs
• Use column hide for easier copying
• Use Available Macro or Format Style to Paint Input Cells
Financial Modelling Apr 21, 202354
Operating Assumptions in Model
Once the working sheet data has been developed compute the three basic operating inputs:
Capital expenditures
Revenues
Operating expenses
• When you get a model from someone else find these three inputs and work backwards
• History should be presented along with forecasts for the value drivers
Financial Modelling Apr 21, 202355
Workings Analysis Issues
• Combine historic financial statement data with selected operational data
The operational data is most difficult to find, but you do not need much
• For each line item in the financial statements, show ratios for the items and show assumptions for the ratios
• The key is to isolate real economic drivers such as price, capacity utilization, market share and other things that really drive value
• Arrange by Revenues, Expenses, Capital Expenditures, Working Capital and Depreciation
• Compute change in working capital for the cash flow analysis
• If deferred taxes are present, compute book and tax depreciation
Financial Modelling Apr 21, 202356
Relate Capacity to Demand
• Begin with demand and then express the demand in terms of required capacity
• Relate the capacity to demand
Use a ratio of demand to capacity
Reserve margin that relates demand to required capacity
Class rooms needed at capacity
Max towers per subscriber
Retail outlets per level of sales
Once you have the maximum capacity, test the capacity against the level of sales.
Use the roundup command in excel
Financial Modelling Apr 21, 202357
Value Drivers and Starting Point of Forecast
• Demand Driven Forecast (Telecommunications)
Begin with market size, industry demand and derive volumes
Volume = Industry Demand x Market Share
Capacity requirements come from volume and maximum utilization
Drivers and Market Size, Market Penetration, Market Share and Price
• Capacity Driven Forecast (Commodity Markets)
Begin with capacity instead of demand and determine volumes from capacity utilization multiplied by capacity
Inputs driven by technical efficiency parameter
New capacity driven by corporate strategy
Drivers are capacity, capacity utilization, and price
Financial Modelling Apr 21, 202358
Value Drivers and Starting Point of Forecast
• Asset Driven Forecast (Retail Banks, Investment Companies)
Begin with asset and liabilities
In banks, use deposit growth and loan to deposit ratios
Investments (like capital expenditures) are increases in loans
Financial Modelling Apr 21, 202359
Examples of Value Drivers
• Economic and business variables that directly affect cash generation:
Price per unit sold
Volumes sold
Penetration rates in theme park
Market share of telecommunications firm
Sales per square foot
Cost per ton
Occupancy rates
Cost of capacity per new subscriber
Cost of replacing oil reserves per bbl
• Main drivers that should be utilized to prepare sensitivity analysis
• Correlation with macro-economic variables may be useful
Financial Modelling Apr 21, 202360
Working Through Drivers
• Use revenue components from income statement
Relate revenue components to available volume data
Relate volume data to capacity data
Example – Airline planes and passenger traffic related to passenger revenues; number of planes is capacity; passenger miles is volume
• Use operating expense components from income statement
Relate to same volume and capacity data as revenues
Split into fixed and variable costs if possible
• Use corporate strategy for capital expenditures
Determine cost of capital expenditures per capacity
Split between maintenance capital expenditures and expenditures for new additions
Financial Modelling Apr 21, 202361
Index with Different Periodic Intervals
• When setting-up a model, it may seem that establishing an inflation index is straightforward and simply a matter of multiplying one plus the inflation rate by the prior inflation index. One must be careful in defining the base period for which prices are defined and escalate from that period. Difficulties can arise when time period lengths change and when intervals are used for inputting the inflation rate. Discussion of looking-up data using the MATCH and FUNCTION functions is discussed later. The step by step process below illustrates how to deal with varying periods. This process involves converting annual rates into daily rates and computing the index from the number of days in the period. The procedure is analogous to verification of the XIRR discussed in the output section
• Step 1: Convert the annual rate into a daily rate using the formula (1+Annual Rate)^(1/365)-1.
• Step 2: Beginning with 1.0 for the base period, compound the index through multiplying the prior index by (1+daily rate)^(days in period)
Financial Modelling Apr 21, 202362
Intervals and Looking up with Match and Index
• Use of Ranges
Match and Index Command (Using 1 or -1 in match)
Avoids problems with blanks
Can use descending tables (e.g. for sweep criteria)
Use to Row
Integrated Financial Management Apr 21, 2023
Debt Schedule
Financial Modelling Apr 21, 202364
Debt Schedule Discussion
• Basics
Debt Corkscrew with Opening and Closing Balance
Use of Minimum Function (rather than if statement) to assure that repayments do not exceed the opening balance
• Other Issues with Debt
Grace period
Level payment
Customized repayment using solver
Financial Modelling Apr 21, 202365
Debt Sheet
• The debt module to model includes the total of all debt derived from the sources and uses statement.
• Each debt issue should show at minimum the beginning debt balance, debt draws, debt repayments, interest expense and ending debt balance.
Use a separate module and put interest expense and debt repayments etc. in the financials
Reflect the actual repayment structure and the quarterly or semi-annual repayments.
Include interest expense in the income statement from the debt module - make sure that EBT subtracts interest expense.
Financial Modelling Apr 21, 202366
Modelling Defaults on Debt
• Modelling defaults on debt is important in credit analysis. Through modelling defaults, the probability of default and the loss given default can be evaluated through break-even analysis and through Monte Carlo simulation.
• The following process shows how to model defaults:
Set up the debt balance to incorporate defaults and re-payment of defaults
The default comes from an if statement in the cash flow statement
The re-payment of default is the previous year default amount. This means the model attempts to fully repay the default in the year immediately following the default. If there is no cash flow to repay the default, the default increases by the amount of the default.
Financial Modelling Apr 21, 202367
Relationship Between Debt Schedule and Cash Flow Schedule in Structured Finance
• This shows the linking of the debt schedule and the cash flow statement
Debt Schedule
Opening Balance
New Issues
Repayments
Default
Repayment of Default Repay after default
Cash Flow Statement
Operating Cash Flow
Plus Interest
Net Cash Flow to Pay Debt Service and Dividends
Attempt to pay all debt service including repayment of default
If positive, flows to next section of the cash flow
If insufficient cash after debt service, default
Financial Modelling Apr 21, 202368
Default Mechanics
• Steps in computing default and repayment of default
Compute default in cash flow statement by structuring a cash flow waterfall
Assume all defaulted debt is paid in subsequent period, before any other debt service
If cash is insufficient to pay debt service and re-payment of default, default will be larger and will attempt to repay larger default
Example
Default Year 1 100
Cash Flow Year 2 -50
Year 2
Cash flow (50) Repayment of Default from year 1 (100) Total Cash Flow (150) Default in year 2 150
Financial Modelling Apr 21, 202369
Modelling Defaults on Debt - Procedure
• The following illustrates the modelling process for defaults.
Note how the default comes from the cash flow statement
The if statement in the cash flow statement
The repayment of default from the prior default
Financial Modelling Apr 21, 202370
Cash Sweep and Cash Trap Mechanics – Surplus used to Prepay Debt
• This shows the linking of the debt schedule and the cash flow statement from cash trap or cash sweep covenants
Debt Schedule
Opening Balance
Less: Scheduled Repay
Prepayments - Covenant
Closing Balance
Remaining Debt for Sweep – Opening balance les repayment
Cash Flow Statement
Operating Cash Flow
Plus Interest
Net Cash Flow to Pay Debt Service and Dividends
Attempt to pay all debt service including repayment of default
If covenant is triggered, use trap or sweep cash (subject to test)
If covenant is not triggered, allow cash to flow to equity or next level
Financial Modelling Apr 21, 202371
Effect of Cash Sweep With Declining Cash Flows
• No Enhancements • With Cash Flow Sweep
(5,000.00)
-
5,000.00
10,000.00
15,000.00
20,000.00
25,000.00
30,000.00
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
2035
2036
2037
2038
2039
2040
On-Shore Wind PPA, Wrapped EPC, O&M Contract, Fixed Interest Rate 1.3
Equity IRR 5.9% Minimum DSCR - Leverage 86.4% Capacity Factor Sensitivity 78% Price Sensitivity 100%
Dividends
Junior Debt Service
Trap and Sweep
Senior Debt Service
DSRA Flows
Cash From Operations
With declining cash flows, the break-even point reduces significantly
(5,000.00)
-
5,000.00
10,000.00
15,000.00
20,000.00
25,000.00
30,000.00
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
2035
2036
2037
2038
2039
2040
On-Shore Wind PPA, Wrapped EPC, O&M Contract, Fixed Interest Rate 1.3
Equity IRR #NUM! Minimum DSCR - Leverage 86.4% Capacity Factor Sensitivity 68% Price Sensitivity 100%
Dividends
Junior Debt Service
Trap and Sweep
Senior Debt Service
DSRA Flows
Cash From Operations
Without enhancements, the break-even is 78%
With a sweep, the break-even is 68%
Dividends Cash Sweep
Financial Modelling Apr 21, 202372
Cash Trap Mechanics
• Set up Cash Reserve Account and Relate to the Cash Flow Statement
Cash Reserve
Opening Balance
Cash Inflows
Cash Outflows
Ending Withdrawals
Interest Income
Cash Flow Statement
Operating Cash Flow
Add: Cash Balance
Add: Interest Income
If positive cash and debt outstanding, trap cash
If negative cash and positive cash balance, use cash
If paid off debt and positive cash flow, withdraw all cash
Subtract: Cash Balance
Financial Modelling Apr 21, 202373
Cash Flow Waterfall
• Waterfall Issues
Defaults and subsequent repayments of defaults before dividend distributions
Model different priorities of debt
Model cash flow trap mechanisms
Evaluate Pre-payments from covenant violations
Compute Debt service reserve injections and withdrawals
Accumulation of debt service reserve after construction period
Financial Modelling Apr 21, 202374
Cash Flow Traps and Dividends
• After junior debt is evaluated, traps on cash and distributions can be evaluated.
• You must subtract the cash balance that was added at the beginning of the waterfall
• Cash Traps can be evaluated at this point that prevent excess cash going dividends before debt is paid
This step of the waterfall is illustrated below:
Cash Flow after Junior Debt
Add: Default on Junior Debt Less: Cash Balance Added Above
Net Cash Flow
Switch for Trapping Cash Less: Cash Trapped Add: Cash Withdrawn from Account
Dividend Distributions
Financial Modelling Apr 21, 202375
IRR on Senior versus Junior Debt with Different Capital Structures
• More Senior Debt • More Subordinated Debt
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
80% 75% 70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
Equity
IRR
EBITDA Sensitivty
Entry Multiple 11.60 Exit Multiple 9.00 Senior Debt/Capital 43.3% Mezz Debt 27%
Equity IRR
Junior IRR
Senior IRR
Project IRR
Difference in break-even for senior and mezzenine debt
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
80% 75% 70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
Equity
IRR
EBITDA Sensitivty
Entry Multiple 11.60 Exit Multiple 9.00 Senior Debt/Capital 27.0% Mezz Debt 43%
Equity IRR
Junior IRR
Senior IRR
Project IRR
Difference in break-even for senior and mezzenine debt
Integrated Financial Management Apr 21, 2023
Fixed Assets and Depreciation
Financial Modelling Apr 21, 202377
Computing Vintage Amounts
• Step by Step Process
Transpose years to create an index with year born on the vertical column
Compute the age of the plant –
year of model minus year born + 1
Use relative references
Allow negative numbers before born
Use HLOOKUP to compute the rate (better than match and index)
Use SUMIF with test on “<>#N/A” to add all of the amounts
Financial Modelling Apr 21, 202378
Depreciation Expense and Vintage
• Compute straight line depreciation expense
• Multiply the accumulated plant balance from the balance sheet by the depreciation rate
• More complex depreciation modeling – vintage, accelerated, deferred taxes, multiple categories will be covered later
• Models may have separate pages for capital expenditure and depreciation analysis
Financial Modelling Apr 21, 202379
Modeling Amortisation of Fees
• Accumulate fees including fees on committed but unused balance and up-front fees and fees at closing
• Use switch for debt outstanding to compute amortisation of fees
• Compute accumulated amortisation of fees
Integrated Financial Management Apr 21, 2023
Income Taxes in Financial Models
Financial Modelling Apr 21, 202381
Net Operating Loss
• Net operating loss should be part of a reasonably sophisticated model.
• If earnings before tax is less than zero and a simple if statement is used, future years do not get credit for the earlier negative taxable income. Therefore, not including NOL will tend to understate value.
• To model the Net Operating Loss:
First compute taxes without the NOL which allows negative taxes
Create a cork-screw that keeps track of the beginning balance and the additions and subtractions to the NOL
The additions occur when there are negative taxes
The subtractions occur when there is positive tax and a balance in the beginning NOL
The taxes paid are the taxes without NOL plus the inputs to the NOL minus the withdrawals from the NOL.
Financial Modelling Apr 21, 202382
NOL Example
• The following example illustrates modelling of an NOL
To model the NOL use the following:
An if statement the adds to the NOL when the taxes before NOL are positive
An if statement together with a minimum statement to withdraw from the NOL balance.
Financial Modelling Apr 21, 202383
Expiration of NOL
• Generally, the NOL expires after a period of years (in the US this is now a 30 year period).
• To model expiration of the NOL, all you have to do is add another line in the NOL corkscrew:
Add a line for reductions due to loss of NOL
Use the offset command to model expirations – the offset command with a negative parameter for the column can look back
The formula only applies after the period of the NOL
For example in the case of the US, this would be only after year 6 in the model unless you have data on existing NOL’s and how they arose.
Financial Modelling Apr 21, 202384
Expiration of NOL
• The following example illustrates programming of the NOL with expiration after a certain length of time.
• The two examples shows how expiration of the NOL can reduce its benefit if there is volatility in earnings:
Financial Modelling Apr 21, 202385
Deferred Tax
• Use the following step by step process
Find information on the basis for deferred taxes from the financial statements and concentrate on the deferred tax arising from depreciation and from NOL
Derive the tax depreciation from existing plant
Compute the tax depreciation on new plant from a vintage analysis (shown below)
Create a separate tax calculation after the income statement that accounts for tax depreciation and NOL
Compute the deferred taxes and accumulated deferred taxes from the difference between book and tax
Financial Modelling Apr 21, 202386
Step-up in Tax Basis Computed by Investment Bank
• In an asset purchase rather than a stock purchase, there is a write-up of tax basis
• Compute the new tax basis from purchase price
• Subtract the new tax basis from the new tax basis
• Spread the tax basis over years
Assumptions
Assumed Cash Purchase Price $103.7
Assumption of Liabilities (1) 2,397.0
Adjusted Grossed-Up Basis for Target $2,500.8
December 2004 Asset Tax Basis (2) 1,513.0
Step-up of Tax-Basis $987.7
Tax Rate 39%
Present Value of Cash Tax Savings
Remaining Average Life 20 years 15 years 10 years
Cash Tax Savings per year $19.41 $25.88 $38.82
Discount Rate
6.0% $222.6 $251.3 $285.7
6.5% 213.9 243.3 279.1
7.0% 205.6 235.7 272.6
7.5% 197.9 228.4 266.4
8.0% 190.6 221.5 260.5
Integrated Financial Management Apr 21, 2023
Modeling of Financial Statements
Financial Modelling Apr 21, 202388
Set-up of Financial Section of Corporate Model
• Keep the revenue, expense, working capital and depreciation analysis separate from the model mechanics.
• Make the model mechanics sufficiently complex to handle most situations (deferred items, goodwill, deferred taxes).
• Begin with base year balance sheet
• Incorporate historic financial statements and historic operating analysis
• Include separate analysis of debt issues
• Keep track of shares and allow new debt and equity issues
• Project income statement, cash flow and then balance sheet
Financial Modelling Apr 21, 202389
Cash Flow Waterfall in Project Finance Model
Financial Modelling Apr 21, 202390
Cash Flow Mechanics
• Operating Cash
Begin with Net Income and add back depreciation to derive operating cash.
Increases to working capital (A/R net of A/P) is a reduction in cash flow because revenues are on a billed rather than collected basis.
• Investments
Include pre-paid increases
Include increases or decreases in other investments
Possibly reductions id deferred debits
• Financing
Cash flow before financing (similar to free cash flow) is the number that must be financed.
Dividends should not be negative.
New Equity issues or debt issues are input
• Net Cash Flow
Could be change in short-term debt or cash
Financial Modelling Apr 21, 202391
Computing Cash Flow for the Waterfall
• To model priorities in a cash flow waterfall the first step is setting up a the cash flow statement in a model that reflects the actual ordering of cash flow:
Begin with the cash flow after capital expenditures and after all new financing and acquisitions
Add back interest expense that was deducted because the interest will be accounted for on an issue by issue basis
Add the beginning balance of cash. Even though it seems odd to add the cash balances, these cash balances are available to pay off debt.
The sum of these items gives the cash flow for the waterfall as illustrated below.
Cash Flow After Capital Expenditures
Add: New Debt Issues Add: New Equity Issues
Cash Flow before waterfall adjustments
Add: Total Interest Expense Add: Beginning Cash Balance
Cash Flow for Waterfall
Financial Modelling Apr 21, 202392
Cash Flow Waterfall
• Waterfall Issues
Defaults and subsequent repayments of defaults before dividend distributions
Model different priorities of debt
Model cash flow trap mechanisms
Evaluate Pre-payments from covenant violations
Compute Debt service reserve injections and withdrawals
Accumulation of debt service reserve after construction period
Financial Modelling Apr 21, 202393
Cash Flow Traps and Dividends
• After junior debt is evaluated, traps on cash and distributions can be evaluated.
• You must subtract the cash balance that was added at the beginning of the waterfall
• Cash Traps can be evaluated at this point that prevent excess cash going dividends before debt is paid
This step of the waterfall is illustrated below:
Cash Flow after Junior Debt
Add: Default on Junior Debt Less: Cash Balance Added Above
Net Cash Flow
Switch for Trapping Cash Less: Cash Trapped Add: Cash Withdrawn from Account
Dividend Distributions
Financial Modelling Apr 21, 202394
Cash Flow Priorities
• Once the cash flow for the waterfall is computed, you can compute the defaults on senior and junior debt.
• Subtract scheduled interest payments and maturities from the cash flow for waterfall
• Also subtract attempts to re-pay earlier defaults
• The difference is cash flow after senior debt that determines default – defaults are the driven by an if statement driven by whether there is negative cash flow.
• Any defaults are added to cash flow to determine the cash flow to junior debt
This step of the waterfall is illustrated below:
Cash Flow for Waterfall
Less: Scheduled Repayment Less: Interest on Senior Less: Repayment of earlier defaults
Cash Flow after Senior Debt
Add: Default on Senior Debt Cash Flow to Junior Debt
Less: Scheduled Repayment Less: Interest on Junior Less: Repayment of earlier default
Integrated Financial Management Apr 21, 2023
Temporary Securities and Overdraft Analysis
Financial Modelling Apr 21, 202396
Set-Up of Corporate Model - Accumulated Cash and Notes Payable
• Accumulate balance of cash flow statement in a separate section – cash includes surplus cash balances less short term debt
• Use “If Test” or MIN function to evaluate whether negative balance is short-term debt (positive is temporary securities). Here, could set up minimum cash balance
• Compute interest expense and interest income and add amounts to the income statement
• The computation of interest expense or interest income on average balances causes circularity problems
Interest expense depends on debt balance
Debt balance depends on cash flow
Cash flow depends on interest expense
Financial Modelling Apr 21, 202397
Resolution of Circularity From Interest Expense and Interest Income
• Method 1 – Iteration Option:
Set iteration in options command – problem that can cause the models to be unstable.
• Method 2 – Macro:
Find the source of the problem and create a value instead of a formula. Compute the value in a macro.
• Method 3 – Goal Seek:
Create a row for the difference between computed and a value of interest expense. Use goal seek to find the value and set the difference to zero.
• Method 4 – Solver:
Similar to goal seek, except do with multiple inputs and outputs
Integrated Financial Management Apr 21, 2023
Model Outputs and PresentationGood Presentation is part of a good model
Financial Modelling Apr 21, 202399
Structure of Outputs
• Outputs should generally come from the financial statements and should not affect any of the calculations (you should be able to delete the outputs page without any impact on the model)
• Outputs for comparative graphs can be saved in a separate sheet -- you can develop a macro using a paste as value method to compare scenarios
• Put macro buttons, spinner boxes, combo boxes and scroll bars on the summary page.
• Output Rule: You should be able to delete cells in the output sheet and summary sheet without affecting any of the previous sheets.
Financial Modelling Apr 21, 2023100
Output Presentation – Banking Case
You can use spinner boxes to drive the inputs so the input sheet still has numbers that drive the model
Financial Modelling Apr 21, 2023101
Output Example – Project Finance
Try to summarize key inputs and key outputs on a single page and make the numbers jump out at you
Integrated Financial Management Apr 21, 2023
Complex Modeling Issues
Financial Modelling Apr 21, 2023103
Complex Modeling Issues
• Debt Default and Waterfall (Leveraged Buyouts)
• Net Operating Loss in Income Tax Calculation
• Tax depreciation and retirements (Vintage calculations)
• Deferred taxes and other deferred items (Tax and book depreciation)
• Minority Interest (Similar to equity calculation)
• Constant Capital Structure (Use the solver)
• Monthly to annual flows
• Exchange rates
Financial Modelling Apr 21, 2023104
Example of Deferred Tax Calculation
• The following example illustrates the computation
Financial Modelling Apr 21, 2023105
Modeling Minority Interest
• Increase in minority interest when purchase the company
Source of cash
Liability side of balance sheet
• Model as if purchased the entire company as in prior case
• Minority interest on the income statement
20% of net income of company
No tax impacts
• Minority interest on cash flow
Dividends paid to minority shareholders
Capital Expenditures
Financial Modelling Apr 21, 2023106
Foreign Currency Translation
• Use the interest rate parity theory
Example
Invest 1 Euro at Re
Buy dollars and invest in Rd
Use spot rate to buy dollars Sed Convert dollars to euros in one year through buying euros at the
forward exchange rate Fed Arbitrage
(1+Re) = Sed (1+Rd)/Fed This implies the future spot rate is St = So (1+Rd)/(1+Re)
• Alternatively, use purchasing power parity
Future inflation rate must be consistent with future exchange rate
Financial Modelling Apr 21, 2023107
Use of Solver to Target Capital Structure
• Use solver to find dividends, debt issues or new equity issues depending on the model
• Important for banking cases where capital ratios are important
• To use with macro
Set up the first part of the solver
Use tools, references and click on solver
Use solver solve userfinish = FALSE
See the example target capital structure in the exercises
Financial Modelling Apr 21, 2023108
Use the Min and Max Statements and Switches to Compute Cash Application with Minimum Cash Balance
• Problem
Instead of assuming that cash is all used, assume that minimum cash balance must be maintained
If cash flow is positive, first reduce short-term debt
If cash flow is positive and short term debt is zero, build up cash
If cash flow is negative, first reduce cash
Make sure cash does not go below minimum balance
If cash is more negative, then increase short term debt
Financial Modelling Apr 21, 2023109
Historic Analysis
• Step 1
Summarize Historic Income Statement and Balance Sheet (unlike forecast which is based on income statement and cash flow statement).
• Step 2
Input base year data and other assumptions into calculation section of the worksheet.
• Step 3
Compute ratios from historic data that are necessary for making assumptions such as tax rate, current assets/revenues and payout ratio.
• Step 4
Reconcile items such as capital expenditures, movements in investments, movements in minority interest
Financial Modelling Apr 21, 2023110
• Accumulated depreciation change does not generally reconcile with depreciation expense
• Formula for Added Capital Expenditures
Depreciation Expense less Amortization accounted for Minus Change in Accumulated Depreciation Equals Added Capital Expenditures
• Input Adjusted Capital Expenditures (Change in Net Plant plus Adjustment)
Reconciliation of Capital Expenditure, Depreciation and Amortization
Financial Modelling Apr 21, 2023111
Conversion of Capacity Requirements to Capital Expenditures
• Capital Expenditures for New Capacity
Cost/Unit x New Capacity Required
Difficult to compute retirements
Vintage calculations
Use of offset command
OFFSET(capacity addition,0,- life)
OFFSET(base value,row start,column start (life),length of row,length of col)
• Add Maintenance Capital Expenditures
Analyze Historic Capital Expenditures
Financial Modelling Apr 21, 2023112
Use of Templates and Account Classification in Historic Analysis
• Type in Balance Sheet and Income Statement
• Remove Cash From Current Assets and Notes Payable from Current Liabilities
• Reconcile Capital Expenditures and Equity Balance on Income Statement and Balance Sheet
• Checks
Net income should tie to actual data on the income statement
Balance sheet should reconcile, in particular, the cash balance should tie to actual levels
Financial Modelling Apr 21, 2023113
• Equity balance does not equal prior balance + net income + equity issues - dividends
• Formula for Implied Equity Issues
Change in Common Equity Minus Net Income, plus Dividends Equals Implied Equity Issues
• Input Equity Issues
Reconciliation of Equity Balance, Equity Balances and Dividends
Integrated Financial Management Apr 21, 2023
Reference Slides:Errors in Modelling
Financial Modelling Apr 21, 2023115
Structure of Inputs
• One should be able to find all of the inputs in an easy manner and see how the inputs affect the outputs – this is why the financial statement page should not have any inputs
All inputs should have a color convention so it is clear what numbers can be changed and what should not.
Separate inputs that vary by year (or month) and inputs that are constant.
Other sheets should have links to the input page where the inputs are repeated on the top of the page
• Examples of problems with inputs are shown in the reference slides
Financial Modelling Apr 21, 2023116
Single Input Sheet
• If Inputs are all collected on a single sheet
Can find where to change all items (don’t have to look around for switches and inputs)
Easier to develop alternative scenarios with different assumptions
Possible exceptions for interest rate and maturity payments on debt issues
• In the real world, you develop a model with inputs in various places and then re-structure the spreadsheet to collect the inputs in a single sheet.
Financial Modelling Apr 21, 2023117
Input Sheet Example
Financial Modelling Apr 21, 2023118
Example of Difficult Inputs to Find
Inputs in a column far away from the sheet in a sheet that does not have other inputs
Financial Modelling Apr 21, 2023119
More Sophisticated Excel Techniques
• Excel techniques can be helpful in creating input files:
Conditional Formatting
Data Validation
Spinner Boxes
Hyper Links
Column Groups
Use of Filters
Macros with Forms
Offset Function
Financial Modelling Apr 21, 2023120
Use Hyperlinks to Document Assumptions
• Given that the financial model is a database, I like to keep source documents in the spreadsheet, if possible. Hyperlinks can be used to trace each assumption to the original source. In the example below, the hyperlink in the assumption page refers to documents from an investment analyst presentation.
• Explanation of how to insert hyperlinks is shown in the excel background presentation.
• You can also link to another file rather than something in your spreadsheet
Assumption page with hyperlinks
Result of Hyperlink
Financial Modelling Apr 21, 2023121
Financial Statements And Working Sheets – No Inputs in Financial Statements
Putting a Number in a Financial Statement is an Obvious No
Financial Modelling Apr 21, 2023122
Example of Input Number in a Spreadsheet – Percentages and Factors Should be with Inputs
The 10% Factor should be shown explicitly in the spreadsheet
Financial Modelling Apr 21, 2023123
Corrected Sheet with Explicit Presentation of Inputs
II. Colocation Capex (90%)
Core Infrastructure 6,861,293 1,605,625
Civil Works/ MEP 1,347,297 -
Network/ IT 1,155,756 -
Services 297,675 -
Subtotal 9,662,021 1,605,625 Contingency Percent 10% 10%Contingency 1,073,558 178,403 Sensitivity Factor 100% 100%Total Capex 11,809,137 1,962,431
Show the percentages in a separate line item
Financial Modelling Apr 21, 2023124
Inputs in Formulas – Another Example
• This is another example, where an error in depreciation occurred because of the problem of putting numbers in a formula:
By using 50 and 4 the model does not account for changing from quarterly to annual periods.
Financial Modelling Apr 21, 2023125
Use Excel Toolbars and Forms to Allow Sensitivity Cases from Multiple Locations
• You allow excel to revise inputs in multiple locations using the view toolbars forms and then using the combo box, the spinner box or the scroll bar.
• This allows you to keep the inputs together and also to adjust the inputs in sheets to examine the effect of the input.
Financial Modelling Apr 21, 2023126
Illustration of Working Through Historic Revenue Items
Revenues from the income statement and volume data input
Financial Modelling Apr 21, 2023127
Illustration of Working Through Expense Items
Retrieve operating expense items from the income statement and relate to revenue drivers, revenue amounts or data obtained from financial reports
Financial Modelling Apr 21, 2023128
Illustration of Demand Driven Forecast - Nokia
• Jorma Olliala: Nokia’s CEO
While uncertainties continued to impact demand, the world handset market was capable of growing between 10% in 2003 from 405m handsests sold in 2002. The company also raised its estimates fro the global number of mobile subscribers from 1.5bn to 1.6bn by 2005. At the same time Nokia reaffirms its belief that it is increasing market share from 38 percent achieved in the first quarter.
Financial Modelling Apr 21, 2023129
Value Drivers
• Basic Motions
Value Drivers are often obvious – prices, traffic etc.
Value drivers for revenues
Price Quantity
Value drivers for operating expenses
Fixed expenses Variable expenses
Value drivers for capital expenditures
Cost per unit of capacity Amount of capacity to meet demand
Demonstrate that value drivers make sense
Compare to history
Evaluate economics
Set up sensitivity analysis and scenario analysis to evaluate the value drivers
Financial Modelling Apr 21, 2023130
Example of Value Drivers for Electricity Plant
• The capital expenditures should be connected to the revenue and expense assumptions. In a supply driven model, the following process would be used
• Capital Expenditures to Grow the Company
Investment Cost Per Unit Of Capacity
On-going maintenance capital expenditures
• Revenues
Product Prices (Price Setter or Price Taker)
Volumes produced –> Capacity x Capacity Utilization
• Operating Expenses
Resource cost -> Resource Price x Resource Use
Resource use -> Efficiency Factor x Volume
Other Fixed, Variable and Overhead Expenses
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Example of Relation Between Value Drivers and Financial Model Inputs
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Consistency between Value Drivers and Inputs
• When demand increases, the capacity requirements increase and the capital expenditures increase.
• Example:
Demand for air freight increases
Increased demand causes a need for more planes
Increased planes create the need for increased capital expenditures
• Create a table with existing capacity, retirements and required new capacity
• Do Not:
Assume revenue growth that is independent of capital expenditures
Assume that cost structure can be maintained with unrealistic capacity utilization assumptions
Use revenue growth/gross margin models that do not demonstrate price and quantity drivers
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Operating Expense Assumptions
• Operating expenses can be separated into three categories:
Fixed expenses that are a function on the size of the project.
Variable expenses that change with the amount of production.
Resource costs that depend on the efficiency of the process.
Labor costs
Expected to increase with inflation. Watch for union contracts. Labor costs can increase with shortages as in the technology sector in the 1990’s.
Production costs. Breakdown into meaningful categories. Includes commodities, energy, research and development.
Selling and administrative costs. Relate to sales or other expenses, but recognize that many costs such as sales force, IT staff are fixed if the company is to survive.
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Checking for Consistency in Value Drivers
• The basic question is whether the drivers are consistent with the company’s economics and industry dynamics:
Company revenue growth consistent with industry
Will competitors retaliate
Can company manage growth
Is the ROIC consistent with the industry
What is happening to barriers to entry
Power of customers
Porters 5 forces and economic theory
How will technology changes affect returns
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Inputs to Develop Financial Projections
• Inputs required for developing financial statements include the following operating and financial assumptions
• Key Operating Data from Working Sheet
Capital Expenditures
Revenues
Operating Expense
Working Capital
Depreciation Expense
• Key Financial and Tax Assumptions
Interest Rate on Future Debt Issues
Future Equity and Debt Issues
Debt Maturities
Dividend Payout Ratio
Income Tax Rate
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Resources and Contacts
• My contacts
Ed Bodmer
Phone: +001-630-886-2754
E-mail: [email protected]
• Other Sources
www.sec.us.gov -- financial documents
www.finance.yahoo.com; www.googlefinance.com; www.valueline.com -- stock prices and financial ratios
www.standardandpoors.com; www.moodys.com – credit rating and other information
www.bondsonline.com – credit spreads
http://pages.stern.nyu.edu/~adamodar