Financial modeling
- Every major company decision is decided by how much the outcome of the decision is worth.
- Firm need a way to figure out how to make those decisions based on the reality of the world
without all the gory detail that’s unnecessary
- Def:
o Involves assessing a future level of cash flow for a particular business or project
o Risks in valuing those cash flows ( from assets, debt, or equity )
Summarizes complex factors into a number ( depend the business model )
- Net present value ( NPV )
- Internal rate of return ( IRR ) ( company we’re considering buying or for our own company )
- Value per share
- Debt service coverage ( internal metric )
Financial model focuses on:
- Decision
- Risks
A good financial model should:
- Be simple
- Focus on key cash flow drivers ( what are the key factors that drive the business forward )
- Convey assumptions and conclusions ( if we assume the revenue will grow at 5% on an annual
basis going forward, for managers + business decision makers )
- Evaluate risks around a business decision:
o Sensitivity analysis
o Break-even analysis
o Scenario analysis
Alternative models
Back of the envelope
- Sanity check on model
Deterministic/ Stochastic ( xac dinh hc ngau nhien )
- Set assumptions
- Compute financial ratios and cash flow
Stochastic:
- Develop range of inputs using Monte Carlo simulation
Excel for Corporate Finance Professionals
Excel for Management Accounting
2. Why financial modeling is important?
Help decision makers make decision:
- Invest in a company, an asset or security?
- Invest in a project ? (building a new factory )
- Do a merger or acquisition deal ?
- Raise capital from the outside markets
Allows decision makers to
- Test scenarios
- Observe potential outcomes
- Make informed decisions
3. Business questions and financial models
Corporate model:
- Three-statement model
o Corporation has a history
o Assume: last indefinitely in the future
o Take cash flow in history, project them for a period of time
o Valuation of a corporation begins with history analysis
o Models must include terminal value assumption (terminal value is the value at the
conclusion of our financial model.)
o Cash flows can’t be projected forever
- Project financial model – discounted cash flow (DCF) model
o Investment characterized by different phases ( investment phases, revenue phases,
closing phase )
o No history for that particular asset
o Focus on projected cash flows of the future
o Entire defined lifetime of the project
- Leveraged buyout (LBO – mo hinh mu alai don bay ) model – Merger and acquisition (M&A)
model
o Defining transaction for a company: one company buying another
o What the purchase price for the enquired company ? – Entry price
o What’s the holding period for this company investment? – Holding period
o Do we sell or exit that investment in the future - Exit price
o Manner of financing
o How alternatives financing sources are repaid ( borrowing from the bank, issue bonds ,
…)
o Return earned by an equity investor
- Merger and acquisition model
- Integrated consolidation model
o Computes earning per share and other financial ratios before and after an acquisition
o Consider specific financing and accounting of the transaction
o Cost savings generated by the transaction
Evaluating Corporate Financial Models: Three-Statement Model
1. Financial modeling strategies
6 steps in building a financial model:
- Going through + gathering the data that we need to build that model: read historic financial
statements
- Go through + change the arrangement of the financial statements: makes sense from a
readability standpoint.
- Go through + compute historical ratios -> make assumption: For ex, looking at AR to sales or
depreciation rate, COGS, revenue,…
- Develop: Revenue, Expense, capital expenditures by working through value drivers
- Work through: Income statement, cash flow statement, balance sheet to check, only for forecast
years.
- Valuation: Sensitivity analysis + presentation: understand where the firm is going in the future,
what the value of company, the expected net income might be as a result.
Note:
- Don’t be obsessed with best practice:
o Bureaucratic
o Waste of time
o Lots of exceptions
- Keep formulas the same, even in base year -> to future years more easily
- Long formulas
- Inputs: keep them together: easy to identify, use
- Logical
2. Sensitivity analysis and financial models
3. Adding visuals to a financial models
Investment Models: DCF model
1. Financial valuation models
Valuation Model:
- Expected future cash flows
- Discount rate
- Terminal value
To compute valuation on an asset
Purpose:
- Project finance
- Company is looking at investing in a specific new asset ( a new factory , a piece of equipment,
R&D project )
Steps:
- Choose starting level of cash flow you’re comfortable with
- Use growth rates based on historical figures
- Choose a discount rate: hardest, because it’s subjective
o Higher risk projects -> higher discount rates
- Decide how growth will change over time: Is the growth beyond the level of forecast
o Constant?
o Tailing off
o No growth
- Terminal value: is major part of valuation: the residual value of the asset after we’re done
forecasting cash flows
o Determine discount rate
o Growth assumptions
2. Cash flows in the valuation model
3. Terminal value in a valuation model
4. Interpreting a DCF model
- DDM ( Dividend Discount Model )
- DCM ( Discounted Cash Flow )
Banking Models
1. Beyond the basics in financial models
Advanced Models
- Needed for modeling buyouts, mergers, acquisitions by private equity firms, large companies
and complicated deals
- Show cash flows in the future
- Show action dependent on those cash flows: ( paying down debt based on the level of cash
that’s available at a company
Three modeling techniques include:
- Corkscrews
- Toggles
- Waterfalls
Advanced models often link multiple simpler models together
- For ex: Buyout model included:
o DCF model
o Three-statement model
( pulls information from the projections based on three-statement model and the DCF model)
Buyout model:
- Give go/ no-go decision on buyouts of other firm
- Projections about cash flows
- Making assumptions about future valuation and interest rates
- Help identify issues that may come up in the near future with the deal
2. Corkscrews and models
3. Waterfalls and models
Waterfalls are a concept used to help deal how profits are split out to various buckets or
stakeholders over time
Cash flow waterfall
- Project operations and maintenance
- Senior debt service ( loans from banks, from bondholders…)
- Senior debt service reserves ( build up a reserve fund/ a rainy reserve fund )
- Aside money in the rainy day fund
- Returns to project sponsor ( equity investor )
4. Adding toggles to a financial model
5. Model outputs
6. Hiding tabs and making models readable
7. Stress testing models
