Presentation on Financial Modeling

Financial ModelingValuation, 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
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
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
Presenting key valuation outputs of a model
Performing sensitivity and scenario analysis on model outputs
Integrated Financial Management
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
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
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
Be relatively simple
Clearly convey assumptions and conclusions
Evaluate Risks through sensitivity analysis, break-even analysis, scenario analysis
Alternative Models
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
This is an example of an completed output
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
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
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
Base Historic Financial Data
Balance Sheet as Anchor
Arrangements by capacity, demand, and cost structure
Working Capital Analysis
Vintage of asset classes and Tax Depreciation
Debt Schedule
Financial Statements
Income Statement
Tax Calculation
Cash Flow
Balance Sheet
Output Sheets
Financial Ratios
Financial Modelling
Revenue, Expense and
Capital Expenditure Analysis
Debt Schedule of
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Components of a Corporate Model – Historic Financial Data, Debt Structure, Working Sheet, Financial Statements and Free Cash Flow
Working Sheet –
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
Income Statement
Beginning Balance
Financial Modelling
Input Sheets
Different colors
Uses and Sources of Funds (Monthly Construction Expenditures)
Conversion from Annual
Depreciation Schedule
Income Statement
Balance Sheet
In a project finance model, the dividends = cash flow
Financial Modelling
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
Inputs –
and Capital Expenditures
Begin with history and drivers as in corporate model
Work through acquisition transaction and compute
Purchase Price
Transaction Multiples
Compute debt schedule from the uses and sources of funds
Profit and loss statement is relatively simple
Cash flow statement has waterfall
Financial Modelling
Input Sheets
Different colors
Uses and Sources of Funds (Monthly Construction Expenditures)
Conversion from Annual
Depreciation Schedule – Include asset write-up and amortisation of intangibles
Income Statement
Balance Sheet
Financial Modelling
Inputs –
Inputs for transaction
Consolidated tax rate, interest rate on new financing, dividend payout ratio, other financing parameters on consolidated basis
Synergies
Sources and Uses of Funds
Goodwill
Target Financials
Buyer Financials
Debt Issues
Target Company Financials
Acquiring Company Financials
Target
Financials
Consolidated
Financial
Statements
Outputs –
Value
Credit
Quality
Transaction &
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
Corporate model – balance sheet
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
Financial Modelling
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
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
Good Modelling Practise
Divide the model into separate modules, beginning with an input section.
Compute how the value drivers determine operating revenues, operating expenses and capital expenditures in a separate “working” module rather than in financial statements.
Understand the starting point of the model as it relates to the valuation issue (balance sheet, sources and uses statement or both).
Carefully define the time period of the model using codes that define alternative phases of the analysis.
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.
Include separate modules for debt issues, fixed plant assets, working capital and cash balances.
Financial Modelling
Good Modelling Practise
Limit or avoid the use of macros and iterations to resolve circular references as circular references are not present in the real world.
Use the balance sheet as an auditing tool and include a separate “integrity” page of model verification checks.
Assure that no formulas in the output module of a model affect anything in any other section of the model.
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).
Include a “dashboard” at the top of each page of the model to monitor the integrity and key outputs of the model.
Keep formulas in the model as simple as possible and clearly delineate how each formula is derived from the inputs.
Use the positive number convention which holds individual elements as positive numbers and performs additions or subtractions in the subtotal items.
Financial Modelling
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
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
The basis for changes in working capital
Common and preferred equity
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
Show units in a column
Use colors to show the sheet derivation
Financial Modelling
General Corporate Models
Switch for Terminal Period
Leveraged Buyout Models
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
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:
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
Setting-up Sensitivity Analysis
Dash Board
Financial Modelling
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
Use of History to Determine Drivers in Corporate Modeling
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
Financial Modelling
You should have an opening balance sheet
Total non-cash current assets
Total non-debt current liabilities
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
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
Operating Assumptions in Model
Once the working sheet data has been developed compute the three basic operating inputs:
Capital expenditures
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
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
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
Demand Driven Forecast (Telecommunications)
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
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
Price per unit sold
Sales per square foot
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
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
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
Use of Ranges
Match and Index Command (Using 1 or -1 in match)
Avoids problems with blanks
Use to Row
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
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
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
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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
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
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
Year 2
Total Cash Flow (150)
Financial Modelling
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
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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
Cash Flow Statement
Operating Cash Flow
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
No Enhancements
Without enhancements, the break-even is 78%
With a sweep, the break-even is 68%
Dividends
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
If negative cash and positive cash balance, use cash
If paid off debt and positive cash flow, withdraw all cash
Subtract: Cash Balance
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
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
Dividend Distributions
Financial Modelling
IRR on Senior versus Junior Debt with Different Capital Structures
More Senior Debt
More Subordinated Debt
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
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
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
Financial Modelling
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
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
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
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
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
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
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
Financial Modelling
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
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
Financial Modelling
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
Add: Total Interest Expense
Add: Beginning Cash Balance
Cash Flow for Waterfall
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
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
Cash Flow after Junior Debt
Add: Default on Junior Debt
Less: Cash Balance Added Above
Net Cash Flow
Dividend Distributions
Financial Modelling
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
Cash Flow for Waterfall
Less: Scheduled Repayment
Financial Modelling
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
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
Financial Modelling
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
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
Output Example – Project Finance
Try to summarize key inputs and key outputs on a single page and make the numbers jump out at you
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
The following example illustrates the computation
Financial Modelling
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
Capital Expenditures
Financial Modelling
Example
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
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
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
Use tools, references and click on solver
Use solver solve userfinish = FALSE
See the example target capital structure in the exercises
Financial Modelling
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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
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
Financial Modelling
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)
Financial Modelling
Capital Expenditures for New Capacity
Cost/Unit x New Capacity Required
Difficult to compute retirements
Add Maintenance Capital Expenditures
Analyze Historic Capital Expenditures
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
Reconciliation of Equity Balance, Equity Balances and Dividends
Equity balance does not equal prior balance + net income + equity issues - dividends
Formula for Implied Equity Issues
Change in Common Equity
Equals Implied Equity Issues
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
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
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
Conditional Formatting
Data Validation
Spinner Boxes
Hyper Links
Column Groups
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
Financial Statements And Working Sheets – No Inputs in Financial Statements
Putting a Number in a Financial Statement is an Obvious No
Financial Modelling
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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
Show the percentages in a separate line item
Financial Modelling
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
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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
Revenues from the income statement and volume data input
Financial Modelling
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
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
Value drivers for revenues
Fixed expenses
Variable expenses
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
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
Volumes produced –> Capacity x Capacity Utilization
Operating Expenses
Resource use -> Efficiency Factor x Volume
Other Fixed, Variable and Overhead Expenses
Financial Modelling
Example of Relation Between Value Drivers and Financial Model Inputs
Financial Modelling
When demand increases, the capacity requirements increase and the capital expenditures increase.
Example:
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 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
Financial Modelling
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.
Financial Modelling
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
Power of customers
Financial Modelling
Inputs required for developing financial statements include the following operating and financial assumptions
Key Operating Data from Working Sheet
Capital Expenditures
Interest Rate on Future Debt Issues
Future Equity and Debt Issues
Debt Maturities
www.standardandpoors.com ; www.moodys.com – credit rating and other information
(5,000.00)-5,000.00 10,000.00 15,000.00 20,000.00 25,000.00 30,000.00
20122013201420152016201720182019202020212022202320242025202620272028202920302031203220332034203520362037203820392040
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%
DividendsJunior Debt ServiceTrap and SweepSenior Debt ServiceDSRA FlowsCash From Operations
Project
Finance
Corporate
Model
LBO
Model
December 2004 Asset Tax Basis
(2)
1,513.0
Remaining Average Life
Discount Rate
6.0% $222.6$251.3$285.7
6.5% 213.9243.3279.1
7.0% 205.6235.7272.6
7.5% 197.9228.4266.4
8.0% 190.6221.5260.5
PPA, Wrapped EPC, O&M Contract, Fixed Interest Rate 1.3
Equity IRR #NUM! Minimum DSCR
-
Dividends
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%
E
qu
i
t
y
I
RREBITDA Sensitivty
Entry Multiple 11.60 Exit Multiple 9.00 Senior Debt/Capital 43.3% Mezz Debt 27%
Equity IRRJunior IRRSenior IRRProject IRRDifference in break-even for senior and mezzeninedebt
Inputs
Operating
Tax Depreciation
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%
E
qu
i
t
y
I
RREBITDA Sensitivty
Entry Multiple 11.60 Exit Multiple 9.00 Senior Debt/Capital 27.0% Mezz Debt 43%
Equity IRRJunior IRRSenior IRRProject IRRDifference in break-even for senior and mezzeninedebt
Mechanics

Documents

Presentation on Financial Modeling