Integrated Financial ManagementMay 15 Financial Modeling.

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


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 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


Model Objectives


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.


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.


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 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


Example of Outputs From a Participant

• 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


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.


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


Alternative Types of Models

ProjectFinance

CorporateModel

LBOModel


Information Base

Contracts and analysis of

Commodity Prices and other value drivers

Historical financialstatements; Analysis

of value drivers


of value drivers; Transaciton Terms


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


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


Architecture of Alternative Models


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


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


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


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


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


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


• Uses and Sources of Funds (Monthly Construction Expenditures)

Conversion from Annual

Computation of Interest During Construction

• Debt Schedule (Sources of Funds)

• Depreciation Schedule


Source and Use of Funds

Income Statement

Balance Sheet

Cash Flow -- Waterfall

• Output Sheets

Valuation - IRR

Debt Service Coverage Ratios


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


Structure of a Project Finance Model


Working Capital AnalysisInputs:

Operating Drivers from

Contractsand Other,

EPC Contract,S-Curve,

Interest Rate

Tax

Profit and Loss


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


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


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


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


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


• 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


Source and Use of Funds

Income Statement

Balance Sheet

Cash Flow -- Waterfall

• Output Sheets

Transaction Multiples

Valuation - IRR

EV/EBITDA and Debt to EBITDA


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


Structure of an Acquisition Model


Working Capital Analysis

Inputs:


History,

AcquisitionPrice andFinancingSources,

Tax

Goodwill andPurchase Price

Allocation

Profit and Loss


Cash Flow Statement With Waterfall,Debt Defaults,Sweeps etc.


BalanceSheet

Equity IRRDebt IRR


Pro-FormaBalanceSheet

DebtSchedule

FixedAssets

Fees andOther



• 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


Structure of an Integrated Consolidation Model

Target Company Financials

Acquiring Company Financials

Inputs:


History,

AcquisitionPrice andFinancingSources,

Tax

Goodwill andPurchase Price

Allocation

Profit and Loss


Cash Flow Statement


BalanceSheet

EPS AccretionCredit Measures


Pro-FormaBalanceSheet

DebtSchedule

FixedAssets

Fees andOther


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


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.


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


Notes on Good Modelling Practices


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


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.


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.


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.


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


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.


Sheet and Color Format

• Use small columns and then large column

• Show units in a column

• Use colors to show the sheet derivation


Time Period Definitions in Models


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


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


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


Modelling Value Drivers


Inputs, Drivers and Working Analysis

• Setting-up Sensitivity Analysis

• Creating Indices

• Working Capital Modelling

• Comparison with Historic Data and Other Metrics

• Dash Board


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


• 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


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


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


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


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


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


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


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


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


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


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)


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


Debt Schedule


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


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.


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.


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


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


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


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


Effect of Cash Sweep With Declining Cash Flows

• No Enhancements • With Cash Flow Sweep

(5,000.00)

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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)

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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


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


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


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


IRR on Senior versus Junior Debt with Different Capital Structures

• More Senior Debt • More Subordinated Debt

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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

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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


Fixed Assets and Depreciation


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


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


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


Income Taxes in Financial Models


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.


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.


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.


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:


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


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


Modeling of Financial Statements


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


Cash Flow Waterfall in Project Finance Model


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


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


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


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

Switch for Trapping Cash Less: Cash Trapped Add: Cash Withdrawn from Account

Dividend Distributions


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 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


Temporary Securities and Overdraft Analysis


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


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


Model Outputs and PresentationGood Presentation is part of a good model


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.


Output Presentation – Banking Case

You can use spinner boxes to drive the inputs so the input sheet still has numbers that drive the model


Output Example – Project Finance

Try to summarize key inputs and key outputs on a single page and make the numbers jump out at you


Complex Modeling Issues


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


Example of Deferred Tax Calculation

• The following example illustrates the computation


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


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


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


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


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


• 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


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


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


• 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


Reference Slides:Errors in Modelling


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


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.


Input Sheet Example


Example of Difficult Inputs to Find

Inputs in a column far away from the sheet in a sheet that does not have other inputs


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


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 Statements And Working Sheets – No Inputs in Financial Statements

Putting a Number in a Financial Statement is an Obvious No


Example of Input Number in a Spreadsheet – Percentages and Factors Should be with Inputs

The 10% Factor should be shown explicitly in the spreadsheet


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


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.


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.


Illustration of Working Through Historic Revenue Items

Revenues from the income statement and volume data input


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


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.


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


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


Example of Relation Between Value Drivers and Financial Model Inputs


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


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.


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


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


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

Integrated Financial ManagementMay 15 Financial Modeling.

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