FINA 4050A

Class 6: Financial Modeling

Basics

Prof. Chew Seen Meng

28 Oct, 2020
 Tact is for people
not witty enough to be sarcastic.
--Anonymous
 Exhibit 1: Course Layout: Mergers,
Acquisitions, and Other
Restructuring Activities

Part I: M&A Part II: M&A Process Part III: M&A Part IV: Deal Part V: Alternative
Environment Valuation and Structuring and Business and
Modeling Financing Restructuring
Strategies

Ch. 1: Motivations Ch. 4: Business and Ch. 7: Discounted Ch. 11: Payment and Ch. 15: Business
for M&A Acquisition Plans Cash Flow Valuation Legal Considerations Alliances

Ch. 2: Regulatory Ch. 5: Search through Ch. 8: Relative Ch. 12: Accounting Ch. 16: Divestitures,
Considerations Closing Activities Valuation & Tax Considerations Spin-Offs, Split-Offs,
Methodologies and Equity Carve-
Outs

Ch. 3: Takeover Ch. 6: M&A Ch. 9: Financial Ch. 13: Financing the Ch. 17: Bankruptcy
Tactics, Defenses, Postclosing Modeling Basics Deal and Liquidation
and Corporate Integration
Governance

Ch. 10: Private Ch. 14: Applying Ch. 18: Cross-Border

Company Valuation Financial Models to Transactions
Deal Structuring
 Learning Objectives
• Primary learning objective: To help students understand the
power (and limitations) of financial models in analyzing the
impact on firm value of changing key assumptions (“What if
analyses)
• Secondary learning objectives: Through “hands on” application,
students will learn how the various steps of the modeling
process
– Help to identify the primary determinants of firm cash flows
(Step 1 of the modeling process),
– Require 3 to 5 year projections of annual cash flows during
the “planning period” (Step 2 of the modeling process), and
– Require the estimation of the present value of projected
annual cash flows, including a terminal value (Step 3 of the
modeling process)
 The Role of Financial Models
in Problem Solving
• Financial models are mathematical representations of
the financial and operational characteristics of a
business.
• Applications involving financial modeling include the
following:
– Management decision making (i.e., determining key
value drivers)
– Capital budgeting (i.e., evaluation of investment
opportunities)
– Firm value estimation and
– Risk analysis (e.g., Monte Carlo simulation)
• The focus in this presentation is on applying modeling
to firm valuation under alternative scenarios
 Model Data Requirements

• Quality of model output

– Dependent on reliability of data used to build the
model and
– Credibility of the assumptions underlying cash flow
projections
• Consequently, model users must understand the source
of data (i.e., audited by trusted party) and how it is
reported (GAAP or pro forma)
– Always use primary data sources when possible such
as the 10K available for public firms
– Footnotes to the financial statements in 10ks explain
the detail underlying each line item
 Financial Statements
• Generally Accepted Accounting Principles (GAAP) Statements
– GAAP financial statements are those prepared in agreement with
guidelines established by the Financial Accounting Standards Board.
– GAAP rules-based system
• International Accounting Standards (IAS)
– IAS financial statements are a principles-based system, with more
generalized standards.
– GAAP and IAS currently exhibit significant differences.
• Pro Forma Accounting Financial Statements
– Present financial data in a way that may describe more accurately a
firm's current or projected performance.
– May deviate substantially from GAAP statements.
– Show what an acquirer's and target's combined financial performance
would look like if they were merged.
 Financial Statement Linkages
Income Statement Balance Sheet Cash Flow Statement
Assets Liabilities Net Income
+ Depreciation
Revenue Cash Current Liabilities - ∆Current Assets
+ ∆Current Liabilities
- Cost of Sales + Other Current + Revolving Credit = Cash from Operating
Assets
+ Interest Income Capital Expenditures
+ Long Term Assets + Long-Term Debt + Asset Sales
- Interest Expense = Cash from Investing
= Total Assets = Total Liabilities
= Income Before Net Change in Equity1
Taxes Retained Earnings + Net Change in Debt2
- Dividends Paid
- Taxes + Paid in Surplus = Cash from Financing

= Net Income + Other Net Change in Cash3

+ Beginning Cash Balance
= Shareholders’ Equity = Cash Available to Repay
Revolving Credit
Balance4
- Repayment5
= Ending Cash Balance
Notes: 1New equity issues less repurchases
2New borrowing less debt repayment
3Sum of cash from operating, investing, and financing activities
4Cash available to repay revolving credit balance in excess of the firm’s desired minimum balance.
5Payment made to reduce outstanding revolving credit balance in excess of the firm’s desired minimum balance.
 Financial Model Circularity

Interest Expense Reduces

Net Income

Lower Net Income

Higher Debt Outstanding
Reduces Cash Available
Increases Interest Expense
to Repay Debt

Lower Cash Available to

Repay Debt Increases Debt
Outstanding
 Resolving Circular References
• Circular references occur when the last cell reference in a series of cell
references refers to the first cell reference resulting in a closed loop

• Circular references could result in the financial model becoming unstable

with Microsoft’s Excel showing any of the following error messages: REF!,
#Value, or Div/0!

• To resolve (allow) circular references using Microsoft’s Excel, turn on the

iteration command for Windows 7 or 8 as follows:

--On the ribbon bar, click on File >>> Options >>> Formulas

--Set workbook calculation to Automatic and enable Iterative Calculation

--Set maximum number of iterations to 100 and the maximum amount of

change to .001.
 Toggle Buttons
• An alternative means of resolving circular references is to
use ”toggle buttons” which indicate a state such as Yes/No
or On/Off
• “Toggle buttons” are used in the model accompanying this
text on the income statement (interest income & expense
rows) and debt repayment (revolving credit facility row)
worksheets

• Such buttons are used by switching the interest

income/interest expense or revolving credit facility “toggle
button” on and off and on (i.e., from 1 to 0 to 1)
 Key Steps in the Valuation Process

• Step 1: Analyze the target firm’s historical

financial statements to identify the primary
determinants of cash flow. Input historical data.
• Step 2: Project three-to-five years (or more) of
annual pro forma financial statements. This
three-to-five year period is called the planning
period.
• Step 3: Estimate the present value of the
projected pro forma cash flows, including the
terminal value.
 Step 1: Analyze Recent
Financial Statements
• Identify “value drivers” or variables highly correlated
with with operating cash flows and in turn firm value
• To do so, normalize historical data by adding large
non-recurring losses (e.g., one time severance
expenses) and subtracting one-time gains (e.g.,
asset sales)
• Key value drivers include the sales growth rate and
cost of sales as a percent of sales
• Gross margin (the difference between revenue and
cost of sales) for many nonfinancial firms
summarizes a firm’s ability to create value
 Sales Growth and Profit Margins

• Sales growth and profitability are determined by

both industry and firm specific factors.
• To understand what governs sales and profits
evaluate
– Industry-specific factors: Industry attractiveness
in terms of intensity of competition and potential
profitability (5-Forces Model)1 and
– Firm-specific factors: The firm’s competitive
positions within the industry
1Customers, suppliers, current competitors, new entrants, and substitutes.
 Industry-Specific Factors
Affecting Profitability
Porter Model: Characteristics of High Profit Versus Low Profit Industries1

High Industry Profits are associated Low industry profits are associated
with: with:
Weak suppliers Strong suppliers

Weak customers Strong customers

High entry barriers Low entry barriers

Few substitutes Many substitutes

Little rivalry/competition Intense rivalry/competition

1The terms strong and weak refer to the bargaining power of customers and suppliers relative to the firm being analyzed.
 Firm-Specific Factors
Affecting Profitability
• Revenue reflects a firm’s pricing power, ability to gain market share, and the
growth in product demand in the industry.
– Pricing power tends to be less in highly competitive markets than in less
competitive ones such as those selling differentiated products
– Unit sales growth driven by growth in industry product demand and market
share gains (e.g., demographics drive personal care product demand)
– Market share gains affected by new product development, differentiations,
and pricing strategies
• Cost of sales reflects cost of direct labor, materials and how inventory is valued
– Direct labor costs affected by labor availability, degree of unionization,
government regulation, and productivity
– Purchased material costs affected by size of purchase, number of suppliers,
product uniqueness and availability of substitutes
– During inflationary periods, LIFO cost of sales higher than FIFO
 Target Historical Income Statement
Actual
2011 2012 2013
Sales $ 3,588.1 $ 3,775.7 $ 3,958.5
Cost of Goods Sold 1,482.0 1,665.7 1,664.1
Gross Profit 2,106.1 2,110.0 2,294.4
SG&A 1,023.2 1,009.0 1,054.6
Other Operating Expense 470.7 453.2 414.6
Depreciation 123.0 123.6 126.0
Amortization 299.6 313.9 302.9

EBIT 189.6 210.3 396.3

Unusual (Gain) Loss (37.2) - -
(Income) from Affiliates - -
Other Expense (Income) 60.0 10.9 11.9
Interest (Income) (4.3) (3.9) (2.4)
Interest Expense 152.3 162.1 123.9

Earnings before Taxes 18.8 41.2 262.9

Non-controlling Interest - - -
Taxes 63.7 100.9 101.4

Net Income before Extra Items (44.9) (59.7) 161.5

Extraordinary Items 0.6 0.7 0.4

Net Income after Extra Items $ (44.3) $ (59.0) $ 161.9

 Input Versus Formula Model Cells

• Cells containing formulas are in black

• Cells highlighted in yellow are input cells
– Changes to the content of these cells will fill in
all cells containing formulas.
– When replacing pre-existing data, it is helpful
to change the color of those cells for which
the data inputs have been made.
• Red cells at the bottom of the balance sheet
worksheets should be zero indicating the model
is in balance.
 Model Hints
• Once historical data and forecast assumption data entered
into the model, save the model.
• Make additional changes to copies of the saved model
– If model errors arise and cannot be resolved, it is
helpful to return to an earlier copy of the model.
• Make sure the model’s balance sheet “balances” denoted
by red cells at bottom of balance sheet worksheet equal to
zero.
• Do not worry about fine-tuning the model forecast until
after the model “balances.”
• Fine-tuning the model forecast should start with a focus on
making small changes to model value drivers one at a
time
 Step 2: Project Pro Forma
Financial Statements
• If the factors affecting historical cash flow expected
to remain the same in the future, extrapolate
financial statements based on historical growth
rates.
• If historical factors expected to change,
extrapolation will not work.
• Financial statements should be projected at least 3
- 5 years or more until the firm’s cash flows turn
positive or the growth rate slows to what is believed
to be a sustainable pace.
 Target Assumptions Worksheet
Projections for the Period Ending December
Actual 31,
2011 2012 2013 2014 2015 2016 2017 2018

Income Statement

Sales Growth NA 5.2% 4.8% 5.5% 5.5% 5.5% 5.5% 5.5%

COGS as a % of Sales 41.3% 44.1% 42.0% 43.0% 43.0% 43.0% 43.0% 43.0%
SG&A % annual
increase (decrease) NA (1.4%) 4.5% 4.0% 4.0% 4.0% 4.0% 4.0%
Other Operating
Expense as a % of
Sales 13.1% 12.0% 10.5% 11.0% 11.0% 11.0% 11.0% 11.0%

EBITDA Growth NA 5.8% 27.4% - (0.1%) 7.5% 7.4% 7.4% 7.3%

EBITDA Margin 17.1% 17.2% 20.8% - 19.7% 20.1% 20.5% 20.8% 21.2%

Key Point: Make small changes to assumptions one at a time to assess their impact on
financial statements.
 Step 3: Estimate PV of Projected
Pro Forma Cash Flows

• Estimate

– Weighted average cost of capital (WACC)

– Present value of cash flows during planning

period (i.e., annual forecast period) and

– Cash flows beyond the planning period (i.e.,

terminal period) using constant growth
method
 Calculating WACC
WACC = (D/(D+E)) x [(1-T) x (Cost of Debt)] + (E/(D+E)) x ke where

D = Debt
E = Equity
T = Corporate marginal tax rate (i.e., 40%)
Cost of Debt = 5%
Rf = Risk free rate = 10-year U.S. treasury bond rate = 2.5%
Rm = Return on a broad based stock index
Rm – Rf = Equity risk premium = 5.5%
βl = Levered beta (from finance.yahoo.com) = 1.7
ke = Cost of Equity = Rf + βl(Rm – Rf)
= 2.5 + 1.7(5.5) = 11.9%
D/E = Target debt-to-equity = 30%
D/(D + E) = (D/E)/(1+D/E) = .30 / (1+.30) = .231
E/(D+E) = 1 – [D/(D+E)] = 1 - .231 = .769

WACC = .231 x [(1 - .4) x 5] + .769 x 11.9 = .693 + 9.15 = 9.84%

 Estimate Terminal Value

PTV = FCFFn × (1 + gTV) x discount factor

(WACCTV – gTV)
Where

FCFF2018 = FCFF in year 2018 (i.e., the last year of the planning period), calculated
using the marginal tax rate of 40% rather than an effective tax ratea) = $766
WACCTV = cost of capital assumed beyond year n (2018) and is assumed to equal the
current industry average WACC of 9.4%
gTV = assumed growth rate during the terminal period = 3%
Discount factor (using the mid-year convention) = .66b

PTV = $766 x (1 + .03) / (.094 - .03) x .66 = ($789 / .064) x .66 = $8.09 billion

aThetax rate actually paid by the firm during the planning period.
bRecall that the discount factor equals [1 / (1 + WACC)N] where N is the number of time periods.
 Mid-Year Convention
Calculating the Discount Factor Using the Mid-Year Conventiona

2014 2015 2016 2017 2018

Discount 1/(1+.098)1-.5 1/(1+.098)2-.5 1/(1+.098)3-.5 1/(1+.098)4-.5 1/(1+.098)5-.5

Factor = 1/(1+.098).5 =1/(1+.098)1.5 =1/(1+.098)2.5 = 1/(1+.098)3.5 = 1/(1+.098)4.5
= .95 =.87 = .79 =.72 =.66

aUsing the mid-year convention will result in a larger discounted cash flow valuation than
using full year discounting, because it results in a larger discount factor. For example,
assume cash flow in 2014 is $100 million, using the mid-year convention, its present value
would be $95 million (i.e., [1/(1+.098).5 = .95] x $100 million), but using full year
discounting, it would be $91 million (i.e., [1/(1+.098)1 = .911] x $100 million).
 Things to Remember…
• Financial models are mathematical representations of
the financial and operational characteristics of a
business.
• The process entails the following three steps:
– Step 1: Analyze the target firm’s historical financial
statements to identify the primary determinants of
cash flow.
– Step 2: Project three-to-five years (or more) of
annual pro forma financial statements. This three-
to-five year period is called the planning period.
– Step 3: Estimate the present value of the projected
pro forma cash flows, including the terminal value.