FINANCIAL MODELING
FINANCIAL MODELING
A financial model is the set of relationships that are behind the calcula- tions we perform in putting together the cash budget and the pro forma statements. In financial modeling, we generally focus on the essential features of the budget and statements, and try not to get bogged down in the details. In our Imagined Company example, we looked at the rela- tion between cash and marketable securities, but we avoided getting into detail of where the cash is held or which securities we buy or sell.
SELECTED TOPICS IN FINANCIAL MANAGEMENT
EXHIBIT 29.11 Imagined Company Long-Term Planning, 2005 through 2010
Panel a: Cash Budget
Projected Sales $20,000 $22,000 $25,000 $26,000 $27,000 $28,000 Operating Cash Flows
Cash Inflows Cash sales
$2,600 $2,700 $2,800 Collections on account:
22,040 24,100 26,270 Operating cash inflows
$21,000 $22,020 $23,750 $24,640 $26,800 $29,070 Cash Outflows Payments of purchases on account:
$10,067 $10,917 $12,375 $12,958 $13,458 $13,958 Wages
1,300 1,350 1,400 Selling and administrative expenses
2,600 2,700 2,800 Operating cash outflows
$13,067 $14,217 $16,125 $16,858 $17,508 $18,158 Operating net cash flows
Nonoperating Cash Flows Cash inflows Retirement of plant and equipment
$0 $1,000 $2,000 Nonoperating cash inflows
$0 $1,000 $2,000 Cash outflows Maturing long-term debt
$1,000 $1,000 $1,000 Acquisitions of plant and equipment 10,000 7,500 7,500
5,000 1,000 5,000 Payment of cash dividends
400 400 400 Interest on long-term debt
1,520 1,773 1,901 Nonoperating cash outflows
$8,270 $4,473 $8,551 Nonoperating net cash flows
Analysis of cash Cash balance, beginning of year
$1,500 $1,500 $4,000 Net cash flows during year
–488 5,819 4,360 Cash balance without any financing
$1,012 $7,319 $8,360 Long-term debt issuance
244 0 0 Common stock issuance
244 0 0 Available to pay off long-term debt
0 3,319 4,360 Cash balance, end of year
Strategy and Financial Planning
EXHIBIT 29.11
(Continued) Imagined Company Long-Term Planning, Analysis of Accounts
Accounts receivable Year’s beginning balance
$2,000 $1,000 $980 $2,230 $3,590 $3,790 plus, credit sales during the year
$18,000 19,800 22,500 23,400 24,300 25,200 less, collections on accounts
$19,000 19,820 21,250 22,040 24,100 26,270 Year’s ending balance
$1,000 $980 $2,230 $3,590 $3,790 $2,720 Inventory Year’s beginning balance
$2,500 $2,500 $2,500 $2,500 $2,500 $2,500 plus, purchases
10,000 11,000 12,500 13,000 13,500 14,000 plus, wages and other production expenses 1,000 1,100 1,250 1,300 1,350 1,400 less, goods sold
11,000 12,100 13,750 14,300 14,850 15,400 Year’s ending balance
Accounts payable Year’s beginning balance
$2,000 $1,933 $2,017 $2,142 $2,183 $2,225 plus, purchases on account
10,000 11,000 12,500 13,000 13,500 14,000 less, payments on account
10,067 10,917 12,375 12,958 13,458 13,958 Year’s ending balance
$1,933 $2,017 $2,142 $2,183 $2,225 $2,267 Bank loans Year’s beginning and ending balance
$1,000 $1,000 $1,000 $1,000 $1,000 $1,000 Plant and equipment Year’s beginning balance
$10,000 $17,160 $21,701 $25,697 $27,013 $23,772 plus, acquisitions
9,500 7,500 7,500 5,000 3,000 less, depreciation
2,340 2,959 3,504 3,684 3,242 3,213 Year’s ending balance
$17,160 $21,701 $25,697 $27,013 $23,772 $23,559 Long-term debt Year’s beginning balance
$5,000 $6,287 $6,669 $7,234 $6,478 $2,159 plus, long-term debt issued
2,287 1,382 1,564 244 less, long-term debt retired or matured
1,000 1,000 1,000 1,000 4,319 5,360 Year’s ending balance
$6,287 $6,669 $7,234 $6,478 $2,159 –$3,202 Common equity Year’s beginning balance
$8,000 $12,939 $16,995 $21,551 $24,942 $28,678 plus, issuance of new shares of stock
2,287 1,382 1,564 244 0 0 plus, earnings retained during the year
2,652 2,674 2,992 3,146 3,736 4,036 Year’s ending balance
SELECTED TOPICS IN FINANCIAL MANAGEMENT
EXHIBIT 29.11
(Continued) Panel b: Imagined Company Pro Forma Financial Statements, 2005 through 2010 Pro Forma Balance Sheet
Assets Cash and marketable securities
$1,500 $4,000 $4,000 Accounts receivable
2,500 2,500 2,500 Plant and Equipment
27,013 23,772 23,559 Total Assets
$31,927 $34,603 $34,062 $32,779 Liabilities and Equity Accounts payable
$2,183 $2,225 $2,269 Bank loans
1,000 1,000 1,000 Long-term debt
6,478 2,159 (3,202) Stockholders’ equity
24,942 28,678 32,714 Total Liabilities and Equity
Pro Forma Income Statement
Sales $20,000 $22,000 $25,000 $26,000 $27,000 $28,000 less, Cost of goods sold
13,750 14,300 14,850 15,400 less, Depreciation
3,504 3,684 3,242 3,213 Gross profit
$7,746 $8,016 $8,908 $9,387 less, Selling and administrative expenses
2,500 2,600 2,700 2,800 Earnings before interest and taxes
$5,246 $5,416 $6,208 $6,587 less, Interest
400 350 300 250 Earnings before taxes
$4,846 $5,066 $5,908 $6,337 less, Taxes
1,454 1,520 1,773 1,901 Net income
$3,392 $3,546 $4,136 $4,436 less, Cash dividends
400 400 400 400 Retained earnings
In the case of Imagined Company, the following relations between cash inflows and sales are “modeled”:
Second Cash inflows = 10% month’s + 60% month’s + 30% preceding
month’s sales Cash outflows are similar, but instead of collecting on sales and receiv-
sales
ables, we are paying expenses and paying on our accounts payable:
Strategy and Financial Planning
Cash outflows This
This = 20% month’s + 80% month’s +
Last
This
+ month’s 10% month’s purchases
sales sales
purchases
Payments on purchases
Wages Other expenses Purchases are determined by projected sales, so we can rewrite this
as:
Sales
Next This Cash outflows = 20% forecasted
+ 80% month’s + two months 15% month’s
sales sales
out
The cash inflows and outflows from operations are therefore dependent on the forecast of sales in future periods. By changing forecasted sales, the cash inflows and outflows change as well.
We could continue modeling the relations expressed in the cash budget and pro forma financial statements until we have represented all the rela- tionships. Once we have done this, we have our financial model. By play- ing “what if” with the model—changing one item and observing what happens to the rest—managers can see the consequences of their decisions.
Building the financial model forces the manager to think through the relationships and consequences of investment and financing deci- sions. Much of the computation in financial modeling can be accom- plished using computers and spreadsheet programs.
The task of modeling financial relationships is made easier by com- puter programs. Many software packages are available, including:
Excel (Microsoft Corporation) Lotus 1-2-3 (Lotus Development Corporation) VisiCalc (Lotus Development Corporation) Multiplan (Microsoft Corporation)
These programs reduce the modeling effort because they enable the user to program a financial model using understandable phrases instead of programming code.
SELECTED TOPICS IN FINANCIAL MANAGEMENT
BUDGETING AND FINANCIAL PLANNING PRACTICES Based on numerous surveys of budgeting practices in U.S. companies,
we can make some general statements regarding budgeting and financial planning practices: 5
■ Most firms start with sales forecasts. ■ Most use historical data analysis to forecast sales and expenses, though
some use opinions of management and economic models. ■ Most firms have budget manuals, detailing budget procedures and forms to be completed.
The survey indicates the following recent changes in firms’ financial planning:
■ An increasing number of firms have established formal budget pro- grams. ■ There is a decreasing role of Board of Directors in approving budgets. ■ Strategy is becoming more centralized within the companies. ■ There is more frequent updating of long-run plans. ■ There is an increasing use of flexible budgets that separate controllable
and uncontrollable revenues and expenses. Over time, the level of sophistication of capital budgeting in the
United States has increased. This is due to two factors. First, there is an increased awareness of the need to plan a firm’s finances to meet its objective of maximizing owners’ wealth. Second, technological advances in computer software and hardware make financial planning less time consuming and less costly.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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