Financial Modeling

Integrated Financial Management

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

Model Objectives

Integrated Financial Management

May 9, 2015

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.

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

Example of Outputs From a Participant

This is an example of an completed
output

Financial Modelling

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May 9, 2015

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

May 9, 2015

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
wont 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 dont 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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May 9, 2015

Structure of Alternative Models

Financial Modelling

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May 9, 2015

Alternative Types of Models

Financial Modelling

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May 9, 2015

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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May 9, 2015

Architecture of Alternative Models

Integrated Financial Management

May 9, 2015

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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May 9, 2015

Structure of a Standard Corporate Model

Inputs:
Historic
Financials
Operating
Drivers,

Revenue, Expense and

Capital Expenditure Analysis

Working Capital Analysis

Financing,
Tax

Debt Schedule of
Existing Issues

Fixed Asset Schedule

Book and Tax Depreciation
Initial Balance
Sheet

Financial Modelling

Profit and Loss

Fixed Interest
Changing Interest

Taxes Paid, Taxes

Paid and Taxes Deferred

Balance
Sheet

Cash Flow Statement

Free
Cash
Flow

Cash Balance,
Debt Balance
Surplus Cash Balance
Equity Balance

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May 9, 2015

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

May 9, 2015

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

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May 9, 2015

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

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May 9, 2015

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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May 9, 2015

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

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May 9, 2015

Structure of a Project Finance Model

Profit and Loss

Revenue, Expense and

Capital Expenditure Analysis

Taxes Paid, Taxes

Paid and Taxes Deferred

Inputs:
Operating
Drivers from
Contracts
and Other,
EPC Contract,
S-Curve,
Interest Rate
Tax

Working Capital Analysis

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
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May 9, 2015

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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May 9, 2015

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

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May 9, 2015

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

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May 9, 2015

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

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May 9, 2015

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

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May 9, 2015

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
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May 9, 2015

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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May 9, 2015

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

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May 9, 2015

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

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May 9, 2015

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.

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May 9, 2015

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

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May 9, 2015

Notes on Good Modelling Practices

Integrated Financial Management

May 9, 2015

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

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May 9, 2015

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.

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May 9, 2015

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.

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May 9, 2015

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.

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May 9, 2015

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

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May 9, 2015

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.

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May 9, 2015

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

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May 9, 2015

Time Period Definitions in Models

Integrated Financial Management

May 9, 2015

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

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May 9, 2015

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

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May 9, 2015

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

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May 9, 2015

Modelling Value Drivers

Integrated Financial Management

May 9, 2015

Inputs, Drivers and Working Analysis

Setting-up Sensitivity Analysis
Creating Indices
Working Capital Modelling
Comparison with Historic Data and Other Metrics
Dash Board

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May 9, 2015

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

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May 9, 2015

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

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May 9, 2015

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

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May 9, 2015

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 dont 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

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May 9, 2015

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

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May 9, 2015

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

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May 9, 2015

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

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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

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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

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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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

Debt Schedule

Integrated Financial Management

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

Effect of Cash Sweep With Declining Cash Flows

No Enhancements

Without enhancements, the

break-even is 78%

Dividends

With Cash Flow Sweep

With a sweep, the breakeven is 68%

Cash Sweep

With declining cash flows, the break-even point reduces significantly

Financial Modelling

71

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

IRR on Senior versus Junior Debt with Different Capital

Structures
More Senior Debt

Financial Modelling

More Subordinated Debt

75

May 9, 2015

Fixed Assets and Depreciation

Integrated Financial Management

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

Income Taxes in Financial Models

Integrated Financial Management

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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 NOLs and how they
arose.

Financial Modelling

83

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

Financial Modelling

86

May 9, 2015

Modeling of Financial Statements

Integrated Financial Management

May 9, 2015

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

May 9, 2015

Cash Flow Waterfall in Project Finance Model

Financial Modelling

89

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

Temporary Securities and Overdraft Analysis

Integrated Financial Management

May 9, 2015

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

May 9, 2015

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

May 9, 2015

Model Outputs and Presentation

Good Presentation is part of a good model

Integrated Financial Management

May 9, 2015

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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

Complex Modeling Issues

Integrated Financial Management

May 9, 2015

Complex Modeling Issues

Debt Default and Waterfall (Leveraged Buyouts)
Net Operating Loss in Income Tax Calculation
Tax depreciation and retirements (Vintage calculations)
Deferred taxes and other deferred items (Tax and book depreciation)
Minority Interest (Similar to equity calculation)
Constant Capital Structure (Use the solver)
Monthly to annual flows
Exchange rates

Financial Modelling

103

May 9, 2015

Example of Deferred Tax Calculation

The following example illustrates the computation

Financial Modelling

104

May 9, 2015

Modeling Minority Interest

Increase in minority interest when purchase the company
Source of cash
Liability side of balance sheet
Model as if purchased the entire company as in prior case
Minority interest on the income statement
20% of net income of company
No tax impacts
Minority interest on cash flow
Dividends paid to minority shareholders
Capital Expenditures

Financial Modelling

105

May 9, 2015

Foreign Currency Translation

Use the interest rate parity theory
Example
Invest 1 Euro at Re
Buy dollars and invest in Rd
Use spot rate to buy dollars Sed
Convert dollars to euros in one year through buying euros at the
forward exchange rate Fed
Arbitrage
(1+Re) = Sed (1+Rd)/Fed
This implies the future spot rate is
St = So (1+Rd)/(1+Re)

Alternatively, use purchasing power parity

Future inflation rate must be consistent with future exchange rate

Financial Modelling

106

May 9, 2015

Use of Solver to Target Capital Structure

Use solver to find dividends, debt issues or new equity issues depending
on the model
Important for banking cases where capital ratios are important
To use with macro
Set up the first part of the solver
Use tools, references and click on solver
Use solver solve userfinish = FALSE

See the example target capital structure in the exercises

Financial Modelling

107

May 9, 2015

Use the Min and Max Statements and Switches to Compute

Cash Application with Minimum Cash Balance
Problem
Instead of assuming that cash is all used, assume that minimum
cash balance must be maintained
If cash flow is positive, first reduce short-term debt
If cash flow is positive and short term debt is zero, build up cash
If cash flow is negative, first reduce cash
Make sure cash does not go below minimum balance

If cash is more negative, then increase short term debt

Financial Modelling

108

May 9, 2015

Historic Analysis
Step 1
Summarize Historic Income Statement and Balance Sheet (unlike forecast
which is based on income statement and cash flow statement).
Step 2
Input base year data and other assumptions into calculation section of the
worksheet.
Step 3
Compute ratios from historic data that are necessary for making assumptions
such as tax rate, current assets/revenues and payout ratio.
Step 4
Reconcile items such as capital expenditures, movements in investments,
movements in minority interest

Financial Modelling

109

May 9, 2015

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)

Financial Modelling

110

May 9, 2015

Conversion of Capacity Requirements to Capital Expenditures

Capital Expenditures for New Capacity

Cost/Unit x New Capacity Required
Difficult to compute retirements
Vintage calculations
Use of offset command
OFFSET(capacity addition,0,- life)
OFFSET(base value,row start,column start (life),length of row,length of
col)

Add Maintenance Capital Expenditures

Analyze Historic Capital Expenditures

Financial Modelling

111

May 9, 2015

Use of Templates and Account Classification in Historic

Analysis

Type in Balance Sheet and Income Statement

Remove Cash From Current Assets and Notes Payable from Current
Liabilities

Reconcile Capital Expenditures and Equity Balance on Income

Statement and Balance Sheet

Checks
Net income should tie to actual data on the income statement
Balance sheet should reconcile, in particular, the cash balance
should tie to actual levels

Financial Modelling

112

May 9, 2015

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

Financial Modelling

113

May 9, 2015

Reference Slides:
Errors in Modelling

Integrated Financial Management

May 9, 2015

Structure of Inputs
One should be able to find all of the inputs in an easy manner and
see how the inputs affect the outputs this is why the financial statement
page should not have any inputs
All inputs should have a color convention so it is clear what
numbers can be changed and what should not.
Separate inputs that vary by year (or month) and inputs that are
constant.
Other sheets should have links to the input page where the inputs
are repeated on the top of the page
Examples of problems with inputs are shown in the reference slides

Financial Modelling

115

May 9, 2015

Single Input Sheet

If Inputs are all collected on a single sheet

Can find where to change all items (dont have to look around for
switches and inputs)
Easier to develop alternative scenarios with different assumptions
Possible exceptions for interest rate and maturity payments on debt
issues

In the real world, you develop a model with inputs in various places and
then re-structure the spreadsheet to collect the inputs in a single sheet.

Financial Modelling

116

May 9, 2015

Input Sheet Example

Financial Modelling

117

May 9, 2015

Example of Difficult Inputs to Find

Inputs in a column far away

from the sheet in a sheet that
does not have other inputs

Financial Modelling

118

May 9, 2015

More Sophisticated Excel Techniques

Excel techniques can be helpful in creating input files:
Conditional Formatting
Data Validation
Spinner Boxes
Hyper Links
Column Groups
Use of Filters
Macros with Forms
Offset Function

Financial Modelling

119

May 9, 2015

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

Financial Modelling

120

May 9, 2015

Financial Statements And Working Sheets No Inputs in Financial

Statements

Putting a Number in a Financial

Statement is an Obvious No

Financial Modelling

121

May 9, 2015

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

May 9, 2015

Corrected Sheet with Explicit Presentation of Inputs

Show the percentages in

a separate line item

Financial Modelling

123

May 9, 2015

Inputs in Formulas Another Example

This is another example, where an error in depreciation occurred
because of the problem of putting numbers in a formula:

By using 50 and 4
the model does
not account for
changing from
quarterly to annual
periods.

Financial Modelling

124

May 9, 2015

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

May 9, 2015

Illustration of Working Through Historic Revenue Items

Revenues from the income

statement and volume data
input

Financial Modelling

126

May 9, 2015

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

May 9, 2015

Illustration of Demand Driven Forecast - Nokia

Jorma Olliala: Nokias 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

May 9, 2015

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

May 9, 2015

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

May 9, 2015

Example of Relation Between Value Drivers and Financial Model

Inputs

Financial Modelling

131

May 9, 2015

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

Financial Modelling

132

May 9, 2015

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 1990s.
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

May 9, 2015

Checking for Consistency in Value Drivers

The basic question is whether the drivers are consistent with the
companys 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

Financial Modelling

134

May 9, 2015

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

May 9, 2015

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

Financial Modelling

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May 9, 2015