Financial Modeling

Financial Modeling Integrated Financial Management Dec 6, 2016 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 Financial Modelling Dec 6, 2016 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 Dec 6, 2016 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 Dec 6, 2016 Model Objectives Integrated Financial Management Dec 6, 2016 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 Dec 6, 2016 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 Dec 6, 2016 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 Dec 6, 2016 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 Dec 6, 2016 Example of Outputs From a Participant • This is an example of an completed output Financial Modelling 10 Dec 6, 2016 Example of Input Number in a Spreadsheet – Percentages and Factors Should be with Inputs The 10% Factor should be shown explicitly in the spreadsheet Financial Modelling 122 Dec 6, 2016 Corrected Sheet with Explicit Presentation of Inputs Show the percentages in a separate line item Financial Modelling 123 Dec 6, 2016 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 the model does not account for changing from quarterly to annual periods Financial Modelling 124 Dec 6, 2016 Use Excel Toolbars and Forms to Allow Sensitivity Cases from Multiple Locations • You allow excel to revise inputs in multiple locations using the view toolbars forms and then using the combo box, the spinner box or the scroll bar • This allows you to keep the inputs together and also to adjust the inputs in sheets to examine the effect of the input Financial Modelling 125 Dec 6, 2016 Illustration of Working Through Historic Revenue Items Revenues from the income statement and volume data input Financial Modelling 126 Dec 6, 2016 Illustration of Working Through Expense Items Retrieve operating expense items from the income statement and relate to revenue drivers, revenue amounts or data obtained from financial reports Financial Modelling 127 Dec 6, 2016 Illustration of Demand Driven Forecast - Nokia • Jorma Olliala: Nokia’s CEO  While uncertainties continued to impact demand, the world handset market was capable of growing between 10% in 2003 from 405m handsests sold in 2002 The company also raised its estimates fro the global number of mobile subscribers from 1.5bn to 1.6bn by 2005 At the same time Nokia reaffirms its belief that it is increasing market share from 38 percent achieved in the first quarter Financial Modelling 128 Dec 6, 2016 Value Drivers • Basic Motions  Value Drivers are often obvious – prices, traffic etc  Value drivers for revenues  Price  Quantity  Value drivers for operating expenses  Fixed expenses  Variable expenses  Value drivers for capital expenditures  Cost per unit of capacity  Amount of capacity to meet demand  Demonstrate that value drivers make sense  Compare to history  Evaluate economics  Set up sensitivity analysis and scenario analysis to evaluate the value drivers Financial Modelling 129 Dec 6, 2016 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 Financial Modelling 130 Dec 6, 2016 Example of Relation Between Value Drivers and Financial Model Inputs Financial Modelling 131 Dec 6, 2016 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 not demonstrate price and quantity drivers Financial Modelling 132 Dec 6, 2016 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 Financial Modelling 133 Dec 6, 2016 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 forces and economic theory  How will technology changes affect returns Financial Modelling 134 Dec 6, 2016 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 Financial Modelling 135 Dec 6, 2016 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 Financial Modelling 136 Dec 6, 2016 ... 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... Alternative Models Financial Modelling 13 Dec 6, 2016 Alternative Types of Models Financial Modelling 14 Dec 6, 2016 Credit Analysis – Combination of Historic Financial Ratios and Modeling in Establishing... a Corporate Model – Historic Financial Data, Debt Structure, Working Sheet, Financial Statements and Free Cash Flow Working Sheet – Historical Financials Inputs Financial Modelling Revenues,