Financial Modeling
Integrated Financial Management
March 16
Valuation, Decision Making and Risk
Every major decision a company makes is in one way or another derived
from how much the outcome of the decision is worth. It is widely
recognized that valuation is the single financial analytical skill that
managers must master.
•
Valuation analysis involves assessing
 Future cash flow levels, (cash flow is reality) and
 Risks in valuing those cash flows, whether it be the cash flow from
assets, debt or equity
•
Measurement value – forecasting and risk assessment -- is a very
complex and difficult problem.
Reference: Chapter 4
Financial Modelling
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March 16
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
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March 16
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
Financial Modelling
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March 16
Model Objectives
Integrated Financial Management
March 16
Measurement of Risk in Financial Models
•
The fundamental issue in any valuation problem is
how to assess the risk of future cash flow
projections.
•
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 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

Financial Modelling
Use of financial models to directly
assess risks through sensitivity, scenario
and simulation analysis.
6
March 16
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
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March 16
Danger of Believing too Much in Models
•
Alan Greenspan, Financial Times.
“The essential problem is that our models – both risk models and
econometric models – as complex as they have become – are still too simple
to capture the full array of governing variables that drive global economic
reality. A model, of necessity, is an abstraction from the full detail of the real
world.”
•
Nicholas Taleb:
In the not too distant past, say the pre-computer days, projections remained
vague and qualitative, one had to make a mental effort to keep track of them,
and it was a strain to push scenarios into the future. It took pencils, erasers,
reams of paper, and huge wastebaskets to engage in the activity. The activity
of projecting, in short, was effortful, undesirable, and marred with self doubt.
But things changed with the intrusion of the spreadsheet. When you put an
Excel spreadsheet into computer literate hands, you get projections
effortlessly extending ad infinitum. We have become excessively bureaucratic
planners thanks to these potent computer programs given to those who are
incapable of handling their knowledge.
Financial Modelling
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March 16
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
This is not easy but very
important
 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.
Financial Modelling
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March 16
Example of Outputs From a Participant
• This is an example of an completed
output
Financial Modelling
10
March 16
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
Integrated Financial Management
March 16
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
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March 16
Structure of Alternative Models
Valuation Analysis in Alterative types of Models
Valuation from
Model
Base Case Risk
Measurement
Corporate
Model
Project
Finance
LBO
Model
M&A Integration
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
Senior and
Subordianted Debt
Financing and Exit
Multiple
Sources of Funds
Used for Tranasction
and Assessment of
Credit Quality
Weighted Average
Cost of Capital,
Multiples, Terminal
Growth
Debt Capacity, Debt
Terms
Traditional Risk
Assessment from
Equity Perspective
Sensitivity Analysis
Sensitivity Analysis
Sensitivity Analysis
Sensitivity Analysis
and Scenario Analysis
and Scenario Analysis
and Scenario Analysis and Scenario Analysis
of DCF and Multiple
of EPS Accrection and
of Equity IRR
of Equity IRR
Value
Credit Quality
Traditional Risk
Assessment from
Debt Perspective
Break-even Analysis Break-even Analysis
to Determine Ability to to Determine at what
Re-finance and
Point Cash Flow
Maintain Credit Rating Cannot Service Debt
Monte Carlo
Analysis with
Model
Probability Distribution
of EPS and DCF
Valuation
Financial Modelling
Break-even Analysis
to Determine IRR on
Senior and
Subordinated Debt
Break-even Analysis
to Determine
Prospective Credit
Rating
Probability Distribution
Probability Distribution
of Equity IRR and
of Equity IRR, Senior
Probability of DSCR
IRR and Junior IRR
below 1.0
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March 16
Alternative Types of Models
Structure of Alternative Models
Project
Finance
Information Base
Model Starting
Point
Cash Flow Process
Debt Analysis
Model Termination
Model
Complexities
Model Output
Financial Modelling
Corporate
Model
Contracts and
analysis of
Historical financial
Commodity Prices and statements; Analysis
other value drivers
of value drivers
Sources and Uses
Analysis
Cash flow waterfall
that ultimately
measures dividends
paid to equity
Historic Balance Sheet
LBO
Model
M&A Integration
Model
Historical financial
statements; Analysis
of value drivers;
Transaciton Terms
Historical financial
statements; Analysis
of value drivers;
Transaciton Terms
Sources and Uses and Sources and Uses and
Pro-Forma Balance
Pro-Forma Balance
Sheet
Sheet
Net cash flow after
Cash flow changes
Cash flow waterfall
dividends that result in
that result in changes
that ends in dividends
changes in short-term
in short-term debt or
paid to equity
debt or surplus cash
surplus cash
New Debt Issues from
Transaction
New and Existing
New Debt Issues from
Transaction
Existing Debt Issues;
Retired Debt Issues;
New Debt Issues
End of project life
Arbitrary terminal
period
Transaction holding
period
EPS analysis period
NOL; cash traps and
sweeps; construction
NOL; target capital
period issues; debt
structures; circularity;
service reserves; debt depreication vintage
sculpting
NOL; cash sweeps;
Pro-forma balance
interest capitalization
sheet; minority interest
on sub debt; debt
changes; new debt
service reserves;
issues
terminal period
DCF Valuation; EPS
projection; Implied
P/E; Credit Quality
Project EPS and Other
Equity and Debt IRRs;
Ratios on Standalone
Debt/EBITDA
vs Combined Basis
Equity IRR; Project
IRR; DSCR
14
March 16
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
Financial Modelling
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March 16
Architecture of Alternative Models
Integrated Financial Management
March 16
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)

•
Debt Schedule

•
•
Vintage of asset classes and Tax Depreciation
Issue by issue and sum the totals
Financial Statements

Income Statement

Tax Calculation

Cash Flow

Balance Sheet
Output Sheets

Valuation (Market data on Beta etc)

Financial Ratios
Financial Modelling
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March 16
Structure of a Standard Corporate Model
Inputs:
Historic
Financials
Revenue, Expense and
Capital Expenditure Analysis
Profit and Loss
Fixed Interest
Changing Interest
Operating
Drivers,
Working Capital Analysis
Financing,
Tax
Debt Schedule of
Existing Issues
Fixed Asset Schedule
Book and Tax Depreciation
Taxes Paid, Taxes
Paid and Taxes Deferred
Balance
Sheet
Cash Flow Statement
Free
Cash
Flow
Cash Balance,
Debt Balance
Surplus Cash Balance
Equity Balance
Initial Balance
Sheet
Financial Modelling
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March 16
Components of a Corporate Model – Historic Financial Data, Debt
Structure, Working Sheet, Financial Statements and Free Cash Flow
Working Sheet –
Historical
Financials
Inputs
Financial Modelling
Revenues,
Expenses,
Cap Exp, WC
Depreciation
Existing
Debt
Beginning
Balance Sheet
&
Financial
Statements
19
Free Cash
Flow
Outputs –
Value
Credit
Quality
March 16
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
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March 16
Cash Flow Process of a Corporate Model
Income Statement
Analysis of Fixed
Debt Issues
Fixed Interest Expense
Debt Maturities
New Issues
Debt Balance
Net Cash Analysis
Net Cash (Cash – Short-term Debt)
Beginning Balance
Add: Cash Flow
Ending Balance
If Ending Balance > 0, Cash
If Ending Balance < 0, Std
Interest Income = Cash x Rate
Interest Expense = STD x Rate
Financial Modelling
EBIT, Taxes, etc.
Fixed Interest
Short-term Interest
Interest Income
Net Income
Cash Flow
Statement
Net Income, Depreciation etc.
Debt Maturities
Net Cash Flow
Balance Sheet
Surplus Cash Plug
Other Assets.
Short-term Debt
Fixed Debt
Other Liabilities
Common Equity
21
March 16
Sheet Layout – Project Model
•
Plant cot contracts and market drivers
•
Input Sheets
•
•

Different colors

Arranging of inputs
Working Sheets

Arrangements by revenues, expenses and capital expenditures

Arrangements by capacity, demand, and cost structure
Uses and Sources of Funds (Monthly Construction Expenditures)

Conversion from Annual

Computation of Interest During Construction
•
Debt Schedule (Sources of Funds)
•
Depreciation Schedule
•
Financial Statements
•

Source and Use of Funds

Income Statement

Balance Sheet

Cash Flow -- Waterfall
Output Sheets

Valuation - IRR

Debt Service Coverage Ratios
Financial Modelling
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March 16
Basic Project Finance Model Components
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
In a project finance model, the
dividends = cash flow
Mechanics
Construction Sources & Uses
Cash Flow Statement
Balance Sheet
Equity Cash Flow
Project Free Cash Flow
Financial Modelling
Outputs
Income Statement
IRR – Equity
IRR – Project
Net Present Value
Return on Investment
Economic Profit
Debt Service Coverage
LLCR
Payback Period
Accounting Earnings
23
March 16
Structure of a Project Finance Model
Profit and Loss
Revenue, Expense and
Capital Expenditure Analysis
Taxes Paid, Taxes
Paid and Taxes Deferred
Inputs:
Working Capital Analysis
Operating
Drivers from
Contracts
and Other,
EPC Contract,
S-Curve,
Interest Rate
Tax
Sources and
Uses of Funds
During
Construction
Including
Interest
Roll-up
Debt
Schedule
Fixed
Assets
Interest
Capitalized
Fees and
Other
Cash Flow Statement
With Waterfall,
Debt Defaults,
Sweeps etc.
Cash Balance, Debt Balance
Equity Balance
Balance
Sheet
Equity IRR
DSCR, LLCR
Financial Modelling
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March 16
Project Model versus LBO Acquisition Model
• No detailed capital expenditure budget by months and interest during
construction
• Modeling of terminal value and debt outstanding remaining explicit
forecast period that is covered by the terminal value
• Development of pro-forma balance sheet to begin the model from the
sources and uses statement
• Cash flow to debt ratios and valuation ratios to establish terminal value
Financial Modelling
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March 16
Model Sheets in Project Finance Model
Inputs –
Prices, Costs, Capacity,
Technical Parameters
Working Sheet to
Derive Revenues Expenses
and Working Capital
Source and
Use of Funds –
Draw down, IDC, Equity Issues
and Capital Expenditures
Financial Modelling
Debt Schedule –
Debt Balance From
Drawdown Debt Balance,
Interest Expense
Outputs –
Depreciation –
Free Cash Flow,
Equity Cash Flow
Value (IRR), DSCR
Depreciation Expense
Plant Balance
Annual Financials –
Income Statement, Cash Flow –
CASH WATERFALL
and Balance Sheet
26
March 16
LBO Model Structure
• Model Structure is Essential in Modelling Acquisition
 Begin with history and drivers as in corporate model
 Work through acquisition transaction and compute
 Purchase Price
 Consideration
 Sources and Uses of Cash
 Transaction Multiples
 Goodwill
 Pro Forma Balance Sheet
 Terminal Proceeds and Exit Multiple
 Compute debt schedule from the uses and sources of funds
 Profit and loss statement is relatively simple
 Cash flow statement has waterfall
Financial Modelling
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March 16
Sheet Layout – LBO Model
•
Purchase price premium, operating cash flows, terminal value
•
Input Sheets
•
•

Different colors

Arranging of inputs
Working Sheets

Arrangements by revenues, expenses and capital expenditures

Arrangements by capacity, demand, and cost structure
Uses and Sources of Funds (Monthly Construction Expenditures)

Conversion from Annual

Computation of Interest During Construction
•
Debt Schedule (Sources of Funds)
•
Depreciation Schedule – Include asset write-up and amortisation of intangibles
•
Financial Statements
•

Source and Use of Funds

Income Statement

Balance Sheet

Cash Flow -- Waterfall
Output Sheets

Transaction Multiples

Valuation - IRR

EV/EBITDA and Debt to EBITDA
Financial Modelling
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March 16
Model Sheets in Leveraged Buyout Acquisition Model
Inputs –
Purchase Price,
EBITDA, Terminal Value
Debt Schedule –
Debt Balance From
Drawdown Debt Balance,
Interest Expense
Outputs –
Working Sheet to
Derive Revenues Expenses
and Working Capital
Source and
Use of Funds –
Purchase Price
and Capital Structure
Financial Modelling
Depreciation –
Free Cash Flow,
Equity Cash Flow
Value (IRR),
Debt./EBITDA
Depreciation Expense
Plant Balance
Annual Financials –
Income Statement, Cash Flow –
CASH WATERFALL
and Balance Sheet
29
March 16
Structure of an Acquisition Model
Inputs:
Operating
Drivers from
History,
Working Capital Analysis
Acquisition
Price and
Financing
Sources,
Tax
Profit and Loss
Revenue, Expense and
Capital Expenditure Analysis
Sources and
Uses of Funds
Taxes Paid, Taxes
Paid and Taxes Deferred
Debt
Schedule
Fixed
Assets
Fees and
Other
Cash Flow Statement
With Waterfall,
Debt Defaults,
Sweeps etc.
Cash Balance, Debt Balance
Equity Balance
Goodwill and
Purchase Price
Allocation
Balance
Sheet
Pro-Forma
Balance
Sheet
Financial Modelling
Equity IRR
Debt IRR
30
March 16
M&A Integration Model
• Inputs for transaction
 Consolidated tax rate, interest rate on new financing, dividend payout ratio, other
financing parameters on consolidated basis
 Synergies
 Transaction assumptions (transaction price, debt retirement, new debt financing)
• Sources and Uses of Funds
• Goodwill
• Pro-forma Balance Sheet Including Shares
• Target Financials
• Buyer Financials
• Debt Issues
• Depreciation and Tax Adjustments
• Consolidated Financials
• Outputs
Financial Modelling
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March 16
Structure of an Integrated Consolidation Model
Profit and Loss
Target Company Financials
Inputs:
Operating
Drivers from
History,
Acquisition
Price and
Financing
Sources,
Acquiring Company Financials
Taxes Paid, Taxes
Paid and Taxes Deferred
Debt
Schedule
Cash Flow Statement
Sources and
Uses of Funds
Tax
Fixed
Assets
Fees and
Other
Cash Balance, Debt Balance
Equity Balance
Goodwill and
Purchase Price
Allocation
Balance
Sheet
EPS Accretion
Credit Measures
Pro-Forma
Balance
Sheet
Financial Modelling
32
March 16
Sheets in M&A Consolidation
Transaction &
Source and Use
Analysis
Target
Financials
Consolidated
Financial
Statements
Acquirer
Financials
Goodwill &
Pro-Forma
Balance Sheet
Financial Modelling
Outputs –
Value
Credit
Quality
Debt Issues
Including Debt
For Financing
33
March 16
Computation of Consolidation in Model versus Standalone
Model
• The basic principle in consolidation include:
 The starting point is the pro-forma balance sheet instead of a base
historic balance sheet
 For free cash flow items (EBITDA, Cap Exp, Deferred Tax, Working
Capital) -- Use the data from the individual model runs.
 For fixed debt items, use the aggregation of the debt issues as with
normal corporate models
 For new financing, dividends, taxes and equity issues compute the
amounts for the new model.
Financial Modelling
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March 16
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
Financial Modelling
35
March 16
Notes on Good Modelling Practices
Integrated Financial Management
March 16
Best Practices and Good Practices
• It is dangerous to become obsessed with best practices in modelling
 You can become bureaucratic and waste time
 There are almost always exceptions to best practices
 Example
 Keep formulas the same, even in base year
 Use range names in all cells
 Ernst and Young: Rarely use range names
• It is much easier to define bad practice
 Long formulas are the worst single problem
 Keep inputs together and logical
Financial Modelling
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March 16
Good Modelling Practise
1. Divide the model into separate modules, beginning with an input section.
2. Compute how the value drivers determine operating revenues, operating
expenses and capital expenditures in a separate “working” module rather than
in financial statements.
3. Understand the starting point of the model as it relates to the valuation issue
(balance sheet, sources and uses statement or both).
4. Carefully define the time period of the model using codes that define alternative
phases of the analysis.
5. Work through every single balance sheet item showing the opening balance,
changes and the closing balance for each the accounts. This analysis should be
made for everything ranging from cash accounts to common equity.
6. Include separate modules for debt issues, fixed plant assets, working capital
and cash balances.
Financial Modelling
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March 16
Good Modelling Practise
7. Limit or avoid the use of macros and iterations to resolve circular references
as circular references are not present in the real world.
8. Use the balance sheet as an auditing tool and include a separate “integrity”
page of model verification checks.
9. Assure that no formulas in the output module of a model affect anything in any
other section of the model.
10. Make sure that spreadsheet columns are consistent throughout the model
and that the formulas for each column are identical (at least for the forecast
period).
11. Include a “dashboard” at the top of each page of the model to monitor the
integrity and key outputs of the model.
12. Keep formulas in the model as simple as possible and clearly delineate how
each formula is derived from the inputs.
13. Use the positive number convention which holds individual elements as
positive numbers and performs additions or subtractions in the subtotal items.
Financial Modelling
39
March 16
Simple Formulas
• The modeling practices are discussed in another sheet named spreadsheet
conventions.
• The most important is keeping the formulas simple and making the sheets
transparent and easy to read.
•
The following should be in many other lines.
Financial Modelling
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March 16
Balance Sheet as Anchor and Cork-screws
• Use the last historic balance sheet to anchor many accounts. In each case, the
closing balance in the last historic year should come from the balance sheet.
• It is good practice to have accounts for all balance sheet items
• Some examples include:
 The plant balance
 The debt balance
 Net “cash bucket” balance
 The NOL balance
 The Un-amortised debt fee balance
 The basis for changes in working capital
 Common and preferred equity
Financial Modelling
41
March 16
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
42
March 16
Sheet and Color Format
• Use small columns and then large column
• Show units in a column
• Use colors to show the sheet derivation
Financial Modelling
43
March 16
Time Period Definitions in Models
Integrated Financial Management
March 16
Switches in Alternative Models
• Switches for time periods in alternative models
 General Corporate Models
 Switch for History versus Forecast
 Switch for Terminal Period
 Project Finance Models
 Switch for Development Period
 Switch for Construction Period
 Switch for Operation Period
 Switch for Debt Repayment Period
 Leveraged Buyout Models
 Switch for Transaction Period
 Switch for Holding Period
 Switch for Terminal Period
Financial Modelling
45
March 16
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
46
March 16
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
Financial Modelling
47
March 16
Modelling Value Drivers
Integrated Financial Management
March 16
Inputs, Drivers and Working Analysis
• Setting-up Sensitivity Analysis
• Creating Indices
• Working Capital Modelling
• Comparison with Historic Data and Other Metrics
• Dash Board
Financial Modelling
49
March 16
Real World Modelling Process – Corporate Models
• The following six step process
• Step 1: Gather Historic Financial Statements and read them (it is not so
bad)
• Step 2: Change the Arrangement of Financial Statements (See the
example on the subsequent slides)
• Step 3: Compute Ratios from Historic Financial Statements to develop
some of the mechanical assumptions such as A/R to sales and
depreciation rate
• Step 4: Develop Revenue, Expense and Capital Expenditures by
Working through Value Drivers
• Step 5: Work through the Income Statement, then the Cash Flow
Statement, then the Balance Sheet to Check, only for forecast years
• Step 6: Valuation, sensitivity analysis and presentation
Financial Modelling
50
March 16
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
51
March 16
Results of Arranging Inputs
• When you are finished arranging items:
 You should have an opening balance sheet
 Total non-cash current assets
 Total non-debt current liabilities
 Total fixed debt to be repaid
 You should have a debt schedule
 Aggregate of debt issues should tie to balance sheet
 You should have a history of revenues, expenses and depreciation
 Use revenues and expenses and focus on drivers
 Use depreciation to determine the deprecation rate
Financial Modelling
52
March 16
Input Sheet Suggestions
• Set-up combo boxes and scenarios early-on
 Use a part of the sheet for settings and combo box inputs
 Use range names
• Set-up inputs to re-set base case inputs so you don’t lose them in
scenario or sensitivity analysis
• Use data validation for non-numeric inputs
• Use column hide for easier copying
• Use Available Macro or Format Style to Paint Input Cells
Financial Modelling
53
March 16
Operating Assumptions in Model
Once the working sheet data has been developed compute the three basic
operating inputs:
Capital expenditures
Revenues
Operating expenses
• When you get a model from someone else find these three inputs and
work backwards
• History should be presented along with forecasts for the value drivers
Financial Modelling
54
March 16
Workings Analysis Issues
• Combine historic financial statement data with selected operational data
 The operational data is most difficult to find, but you do not need
much
• For each line item in the financial statements, show ratios for the items
and show assumptions for the ratios
• The key is to isolate real economic drivers such as price, capacity
utilization, market share and other things that really drive value
• Arrange by Revenues, Expenses, Capital Expenditures, Working Capital
and Depreciation
• Compute change in working capital for the cash flow analysis
• If deferred taxes are present, compute book and tax depreciation
Financial Modelling
55
March 16
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
56
March 16
Value Drivers and Starting Point of Forecast
• Demand Driven Forecast (Telecommunications)
 Begin with market size, industry demand and derive volumes
 Volume = Industry Demand x Market Share
 Capacity requirements come from volume and maximum utilization
 Drivers and Market Size, Market Penetration, Market Share and Price
• Capacity Driven Forecast (Commodity Markets)
 Begin with capacity instead of demand and determine volumes from capacity
utilization multiplied by capacity
 Inputs driven by technical efficiency parameter
 New capacity driven by corporate strategy
 Drivers are capacity, capacity utilization, and price
Financial Modelling
57
March 16
Value Drivers and Starting Point of Forecast
• Asset Driven Forecast (Retail Banks, Investment Companies)
 Begin with asset and liabilities
 In banks, use deposit growth and loan to deposit ratios
 Investments (like capital expenditures) are increases in loans
Financial Modelling
58
March 16
Examples of Value Drivers
• Economic and business variables that directly affect cash generation:
 Price per unit sold
 Volumes sold
 Penetration rates in theme park
 Market share of telecommunications firm
 Sales per square foot
 Cost per ton
 Occupancy rates
 Cost of capacity per new subscriber
 Cost of replacing oil reserves per bbl
• Main drivers that should be utilized to prepare sensitivity analysis
• Correlation with macro-economic variables may be useful
Financial Modelling
59
March 16
Working Through Drivers
• Use revenue components from income statement
 Relate revenue components to available volume data
 Relate volume data to capacity data
 Example – Airline planes and passenger traffic related to passenger revenues;
number of planes is capacity; passenger miles is volume
• Use operating expense components from income statement
 Relate to same volume and capacity data as revenues
 Split into fixed and variable costs if possible
• Use corporate strategy for capital expenditures
 Determine cost of capital expenditures per capacity
 Split between maintenance capital expenditures and expenditures for new
additions
Financial Modelling
60
March 16
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
61
March 16
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
Financial Modelling
62
March 16
Debt Schedule
Integrated Financial Management
March 16
Debt Schedule Discussion
• Basics
 Debt Corkscrew with Opening and Closing Balance
 Use of Minimum Function (rather than if statement) to assure that
repayments do not exceed the opening balance
• Other Issues with Debt
 Grace period
 Level payment
 Customized repayment using solver
Financial Modelling
64
March 16
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 semiannual repayments.
 Include interest expense in the income statement from the debt
module - make sure that EBT subtracts interest expense.
Financial Modelling
65
March 16
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
66
March 16
Relationship Between Debt Schedule and Cash Flow Schedule
in Structured Finance
• This shows the linking of the debt schedule and the cash flow statement
Debt Schedule
Opening Balance
New Issues
Repayments
Default
Repayment of Default
Repay after default
Cash Flow Statement
Operating Cash Flow
Plus Interest
Net Cash Flow to Pay Debt Service and Dividends
Attempt to pay all debt service including repayment of default
If positive, flows to next section of the cash flow
If insufficient cash after debt service, default
Financial Modelling
67
March 16
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




Financial Modelling
Cash flow
Repayment of Default from year 1
Total Cash Flow
Default in year 2
(50)
(100)
(150)
150
68
March 16
Modelling Defaults on Debt - Procedure
•
The following illustrates the modelling process for defaults.
Note how the default comes from the cash flow statement
The if statement in the cash flow statement
The repayment of default from the prior default
Financial Modelling
69
March 16
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
Remaining Debt for Sweep –
Opening balance les
repayment
Closing Balance
Cash Flow Statement
Operating Cash Flow
Plus Interest
Net Cash Flow to Pay Debt Service and Dividends
Attempt to pay all debt service including repayment of default
If covenant is triggered, use trap or sweep cash (subject to test)
If covenant is not triggered, allow cash to flow to equity or next level
Financial Modelling
70
March 16
Effect of Cash Sweep With Declining Cash Flows
• No Enhancements
• With Cash Flow Sweep
Without enhancements, the
break-even is 78%
With a sweep, the breakeven is 68%
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%
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%
30,000.00
30,000.00
25,000.00
25,000.00
20,000.00
20,000.00
15,000.00
15,000.00
10,000.00
Cash Sweep
Dividends
Junior Debt Service
Junior Debt Service
Trap and Sweep
Trap and Sweep
Senior Debt Service
Senior Debt Service
(5,000.00)
(5,000.00)
With declining cash flows, the break-even point reduces significantly
Financial Modelling
71
March 16
2040
Cash From Operations
2039
2035
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2040
2039
2038
2037
Cash From Operations
2036
2035
2034
2033
2032
2031
2030
2029
2028
2027
2026
2025
2024
2023
2022
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
-
DSRA Flows
-
DSRA Flows
2038
5,000.00
Dividends
5,000.00
2037
Dividends
2036
10,000.00
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
Cash Flow Statement
Interest Income
Operating Cash Flow
Add: Cash Balance
Add: Interest Income
If positive cash and debt outstanding, trap cash
If negative cash and positive cash balance, use cash
If paid off debt and positive cash flow, withdraw all cash
Subtract: Cash Balance
Financial Modelling
72
March 16
Cash Flow Waterfall
•
Waterfall Issues
 Defaults and subsequent repayments of defaults before dividend
distributions
 Model different priorities of debt
 Model cash flow trap mechanisms
 Evaluate Pre-payments from covenant violations
 Compute Debt service reserve injections and withdrawals
 Accumulation of debt service reserve after construction period
Financial Modelling
73
March 16
Cash Flow Traps and Dividends
• After junior debt is evaluated, traps on cash and distributions can be evaluated.
• You must subtract the cash balance that was added at the beginning of the
waterfall
• Cash Traps can be evaluated at this point that prevent excess cash going
dividends before debt is paid
 This step of the waterfall is illustrated below:
 Cash Flow after Junior Debt
 Add: Default on Junior Debt
 Less: Cash Balance Added Above
 Net Cash Flow
 Switch for Trapping Cash
 Less: Cash Trapped
 Add: Cash Withdrawn from Account
 Dividend Distributions
Financial Modelling
74
March 16
IRR on Senior versus Junior Debt with Different Capital
Structures
• More Senior Debt
• More Subordinated Debt
Entry Multiple 11.60 Exit Multiple 9.00
Senior Debt/Capital 27.0% Mezz Debt 43%
Entry Multiple 11.60 Exit Multiple 9.00
Senior Debt/Capital 43.3% Mezz Debt 27%
20%
18%
18%
16%
16%
14%
E
q
u
i
t
y
I
R
R
Difference in break-even for senior
and mezzenine debt
12%
10%
Equity IRR
E
q
u
i
t
y
Junior IRR
8%
Senior IRR
Project IRR
6%
Difference in break-even for senior
and mezzenine debt
14%
12%
Equity IRR
10%
Junior IRR
8%
I
R
R
Senior IRR
Project IRR
6%
4%
4%
2%
2%
0%
0%
80% 75% 70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
EBITDA Sensitivty
Financial Modelling
80% 75% 70% 65% 60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0%
EBITDA Sensitivty
75
March 16
Fixed Assets and Depreciation
Integrated Financial Management
March 16
Computing Vintage Amounts
• Step by Step Process
 Transpose years to create an index with year born on the vertical
column
 Compute the age of the plant –
 year of model minus year born + 1
 Use relative references
 Allow negative numbers before born
 Use HLOOKUP to compute the rate (better than match and index)
 Use SUMIF with test on “<>#N/A” to add all of the amounts
Financial Modelling
77
March 16
Depreciation Expense and Vintage
• Compute straight line depreciation expense
• Multiply the accumulated plant balance from the balance sheet by the depreciation rate
• More complex depreciation modeling – vintage, accelerated, deferred taxes, multiple
categories will be covered later
• Models may have separate pages for capital expenditure and depreciation analysis
Financial Modelling
78
March 16
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
79
March 16
Income Taxes in Financial Models
Integrated Financial Management
March 16
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
81
March 16
NOL Example
• The following example illustrates modelling of an NOL
 To model the NOL use the following:
 An if statement the adds to the NOL when the taxes before NOL are
positive
 An if statement together with a minimum statement to withdraw from
the NOL balance.
Financial Modelling
82
March 16
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
83
March 16
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
84
March 16
Deferred Tax
• Use the following step by step process
 Find information on the basis for deferred taxes from the financial
statements and concentrate on the deferred tax arising from
depreciation and from NOL
 Derive the tax depreciation from existing plant
 Compute the tax depreciation on new plant from a vintage analysis
(shown below)
 Create a separate tax calculation after the income statement that
accounts for tax depreciation and NOL
 Compute the deferred taxes and accumulated deferred taxes from
the difference between book and tax
Financial Modelling
85
March 16
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
Assumptions
Assumption of Liabilities
• Compute the new tax
basis from purchase
price
• Subtract the new tax
basis from the new
tax basis
$103.7
Assumed Cash Purchase Price
(1)
2,397.0
$2,500.8
Adjusted Grossed-Up Basis for Target
December 2004 Asset Tax Basis
(2)
1,513.0
$987.7
Step-up of Tax-Basis
39%
Tax Rate
Present Value of Cash Tax Savings
Remaining Average Life
15 years
20 years
10 years
$19.41
$25.88
$38.82
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
Cash Tax Savings per year
Discount Rate
• Spread the tax basis
over years
Financial Modelling
86
March 16
Modeling of Financial Statements
Integrated Financial Management
March 16
Set-up of Financial Section of Corporate Model
•
Keep the revenue, expense, working capital and depreciation analysis
separate from the model mechanics.
•
Make the model mechanics sufficiently complex to handle most
situations (deferred items, goodwill, deferred taxes).
•
Begin with base year balance sheet
•
Incorporate historic financial statements and historic operating analysis
•
Include separate analysis of debt issues
•
Keep track of shares and allow new debt and equity issues
•
Project income statement, cash flow and then balance sheet
Financial Modelling
88
March 16
Cash Flow Waterfall in Project Finance Model
Financial Modelling
89
March 16
Cash Flow Mechanics
• Operating Cash
 Begin with Net Income and add back depreciation to derive operating cash.
 Increases to working capital (A/R net of A/P) is a reduction in cash flow because
revenues are on a billed rather than collected basis.
• Investments
 Include pre-paid increases
 Include increases or decreases in other investments
 Possibly reductions id deferred debits
• Financing
 Cash flow before financing (similar to free cash flow) is the number that must be
financed.
 Dividends should not be negative.
 New Equity issues or debt issues are input
• Net Cash Flow
 Could be change in short-term debt or cash
Financial Modelling
90
March 16
Computing Cash Flow for the Waterfall
•
To model priorities in a cash flow waterfall the first step is setting up a the cash
flow statement in a model that reflects the actual ordering of cash flow:
Begin with the cash flow after capital expenditures and after all new
financing and acquisitions
Add back interest expense that was deducted because the interest will be
accounted for on an issue by issue basis
Add the beginning balance of cash. Even though it seems odd to add the
cash balances, these cash balances are available to pay off debt.
The sum of these items gives the cash flow for the waterfall as illustrated
below.
 Cash Flow After Capital Expenditures
 Add: New Debt Issues
 Add: New Equity Issues
 Cash Flow before waterfall adjustments
 Add: Total Interest Expense
 Add: Beginning Cash Balance
 Cash Flow for Waterfall
Financial Modelling
91
March 16
Cash Flow Waterfall
•
Waterfall Issues
 Defaults and subsequent repayments of defaults before dividend
distributions
 Model different priorities of debt
 Model cash flow trap mechanisms
 Evaluate Pre-payments from covenant violations
 Compute Debt service reserve injections and withdrawals
 Accumulation of debt service reserve after construction period
Financial Modelling
92
March 16
Cash Flow Traps and Dividends
• After junior debt is evaluated, traps on cash and distributions can be evaluated.
• You must subtract the cash balance that was added at the beginning of the
waterfall
• Cash Traps can be evaluated at this point that prevent excess cash going
dividends before debt is paid
 This step of the waterfall is illustrated below:
 Cash Flow after Junior Debt
 Add: Default on Junior Debt
 Less: Cash Balance Added Above
 Net Cash Flow
 Switch for Trapping Cash
 Less: Cash Trapped
 Add: Cash Withdrawn from Account
 Dividend Distributions
Financial Modelling
93
March 16
Cash Flow Priorities
• Once the cash flow for the waterfall is computed, you can compute the defaults on senior and
junior debt.
• Subtract scheduled interest payments and maturities from the cash flow for waterfall
• Also subtract attempts to re-pay earlier defaults
• The difference is cash flow after senior debt that determines default – defaults are the driven
by an if statement driven by whether there is negative cash flow.
• Any defaults are added to cash flow to determine the cash flow to junior debt
 This step of the waterfall is illustrated below:
 Cash Flow for Waterfall
 Less: Scheduled Repayment
 Less: Interest on Senior
 Less: Repayment of earlier defaults
 Cash Flow after Senior Debt
 Add: Default on Senior Debt
 Cash Flow to Junior Debt
 Less: Scheduled Repayment
 Less: Interest on Junior
 Less: Repayment of earlier default
Financial Modelling
94
March 16
Temporary Securities and Overdraft Analysis
Integrated Financial Management
March 16
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
96
March 16
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
Financial Modelling
97
March 16
Model Outputs and Presentation
Good Presentation is part of a good model
Integrated Financial Management
March 16
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
99
March 16
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
100
March 16
Output Example – Project Finance
Try to summarize key inputs
and key outputs on a single
page and make the numbers
jump out at you
Financial Modelling
101
March 16
Complex Modeling Issues
Integrated Financial Management
March 16
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
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Example of Deferred Tax Calculation
• The following example illustrates the computation
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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
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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
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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
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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
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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
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Reconciliation of Capital Expenditure, Depreciation and Amortization
•
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)
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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
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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
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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
 Minus Net Income, plus Dividends
 Equals Implied Equity Issues
•
Input Equity Issues
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Reference Slides:
Errors in Modelling
Integrated Financial Management
March 16
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
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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.
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Input Sheet Example
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Example of Difficult Inputs to Find
Inputs in a column far away
from the sheet in a sheet that
does not have other inputs
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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
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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.
Result of
Hyperlink
Assumption page
with hyperlinks
• 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
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Financial Statements And Working Sheets – No Inputs in Financial
Statements
Putting a Number in a Financial
Statement is an Obvious No
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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
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Corrected Sheet with Explicit Presentation of Inputs
Show the percentages in
a separate line item
II. Colocation Capex (90%)
Core Infrastructure
6,861,293
Civil Works/ MEP
1,347,297
-
Network/ IT
1,155,756
-
297,675
-
Services
Subtotal
Contingency Percent
Contingency
Sensitivity Factor
Total Capex
Financial Modelling
9,662,021
10%
1,073,558
100%
11,809,137
123
1,605,625
1,605,625
10%
178,403
100%
1,962,431
March 16
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.
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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.
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Illustration of Working Through Historic Revenue Items
Revenues from the income
statement and volume data
input
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March 16
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
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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.
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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
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Example of Value Drivers for Electricity Plant
• The capital expenditures should be connected to the revenue and expense
assumptions. In a supply driven model, the following process would be used
• Capital Expenditures to Grow the Company
 Investment Cost Per Unit Of Capacity
 On-going maintenance capital expenditures
• Revenues
 Product Prices (Price Setter or Price Taker)
 Volumes produced –> Capacity x Capacity Utilization
• Operating Expenses
 Resource cost -> Resource Price x Resource Use
 Resource use -> Efficiency Factor x Volume
 Other Fixed, Variable and Overhead Expenses
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Example of Relation Between Value Drivers and Financial Model
Inputs
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Consistency between Value Drivers and Inputs
• When demand increases, the capacity requirements increase and the capital
expenditures increase.
• Example:
 Demand for air freight increases
 Increased demand causes a need for more planes
 Increased planes create the need for increased capital expenditures
• Create a table with existing capacity, retirements and required new capacity
• Do Not:
 Assume revenue growth that is independent of capital expenditures
 Assume that cost structure can be maintained with unrealistic capacity
utilization assumptions
 Use revenue growth/gross margin models that do not demonstrate price and
quantity drivers
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Operating Expense Assumptions
• Operating expenses can be separated into three categories:
 Fixed expenses that are a function on the size of the project.
 Variable expenses that change with the amount of production.
 Resource costs that depend on the efficiency of the process.
 Labor costs
 Expected to increase with inflation. Watch for union contracts. Labor costs can
increase with shortages as in the technology sector in the 1990’s.
 Production costs. Breakdown into meaningful categories. Includes
commodities, energy, research and development.
 Selling and administrative costs. Relate to sales or other expenses, but
recognize that many costs such as sales force, IT staff are fixed if the company
is to survive.
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Checking for Consistency in Value Drivers
• The basic question is whether the drivers are consistent with the
company’s economics and industry dynamics:
 Company revenue growth consistent with industry
 Will competitors retaliate
 Can company manage growth
 Is the ROIC consistent with the industry
 What is happening to barriers to entry
 Power of customers
 Porters 5 forces and economic theory
 How will technology changes affect returns
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Inputs to Develop Financial Projections
• Inputs required for developing financial statements include the following operating and
financial assumptions
• Key Operating Data from Working Sheet
 Capital Expenditures
 Revenues
 Operating Expense
 Working Capital
 Depreciation Expense
• Key Financial and Tax Assumptions
 Interest Rate on Future Debt Issues
 Future Equity and Debt Issues
 Debt Maturities
 Dividend Payout Ratio
 Income Tax Rate
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Resources and Contacts
• My contacts
 Ed Bodmer
 Phone: +001-630-886-2754
 E-mail: edbodmer@aol.com
• 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
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