Financial Modelling

Financial Modelling in Excel
Indian Institute of Quantitative Finance

Financial Modelling in Excel Indian Institute of Quantitative Finance
Financial Statements
Financial Statements are key esource
available to understand and analyse the
functioning and performance of the
companies.

The financial statements are broken down
into 3 major heads.

The Income Statement
into 3 major heads.

The Statement of Retained Earnings
into 3 major heads.

The Balance Sheet
into 3 major heads.

The Balance Sheet

Income Statement
The first statement prepared is the Income
Statement.
Income Statement
The first statement prepared is the Income
Statement.
The Income Statement reports a business
performance for the period.
Income Statement
A simple format for an income statement is:

Income Statement
A simple format for an income
statement is:

Revenues Expenses = Net Income

Income Statement
A simple format for an income
statement is:

Revenues Expenses = Net Income

Income Statement
Revenues are earned for the sale of goods
or services. Note that revenues occur when
the sale is made. The payment may or may
not have been received.
Income Statement
Revenues are earned for the sale of goods
or services. Note that revenues occur when
the sale is made. The payment may or may
not have been received.
Examples of revenues include sales,
service revenue and interest revenue.
Income Statement
Expenses are incurred when a business
receives goods and services. Like revenues,
payment may or may not have been made.
Income Statement
Expenses are incurred when a business
receives goods and services. Like revenues,
payment may or may not have been made.
Examples of expenses include salaries expense,
utility expense and interest expense.
Income Statement
Most businesses require more information
from their businesses than a simple income
statement can provide. Therefore, they use
a multi-step income statement format.
Income Statement
Most businesses require more information
from their businesses than a simple income
statement can provide. Therefore, they use
a multi-step income statement format.
Income Statement
Sales revenue
- Cost of goods sold
Gross profit
- Operating expenses
Income from operations
+/- Non-operating items
Income before taxes
- Income taxes
Net income
A format for a multi-step income statement is:
Income Statement
Cost of goods sold represents the expense a
business incurred to buy or make a product
for resale.
Income Statement
Cost of goods sold represents the expense a
business incurred to buy or make a product
for resale.
Example - a book store buys a book for $25
and then sells it for $32. The cost of goods
sold is $25.
Income Statement
Operating expenses are the usual expenses
incurred in operating a business.
Income Statement
Operating expenses are the usual expenses
incurred in operating a business.
Accounts such as salaries expense, utility
expense, and depreciation expenses are all
shown in this section.
Income Statement
Non-operating items are revenue,
expenses, gains and losses that do not relate
to the companys primary operations.
Income Statement
Non-operating items are revenue,
expenses, gains and losses that do not relate
to the companys primary operations.
Accounts include interest expense and gains
and losses of the sale of equipment and
investments.
Income Statement
Income taxes are computed by multiplying
Income before taxes by the income tax rate.
Income Statement
Income taxes are computed by multiplying
Income before taxes by the income tax rate.
Example Income before taxes is $50,000.
The income tax rate is 30%. Income taxes
= $50,000 * 30% = $15,000.
The Statement of Retained
Earnings

Statement of Retained Earnings
The Statement of Retained Earnings reports
how net income and dividends affected a
companys financial position during the
period.(also known as reserves and surplus)

The format of the statement is:

The format of the statement is:

Beg. balance, retained earnings
+ Net income
- Dividends
End. balance, retained earnings
Note that the Income Statement must be
prepared before the Statement of Retained
Earnings.
Note that the Income Statement must be
prepared before the Statement of Retained
Earnings.
This is because you have to know the
amount of net income in order to compute
the ending balance of retained earnings.
The Balance Sheet

Balance Sheet
The purpose of the balance sheet is to report
the financial position of an accounting
entity at a particular point in time.(As on
date basis)
Balance Sheet
The purpose of the balance sheet is to report
the financial position of an accounting
entity at a particular point in time.
The basic format for the balance sheet is:
Assets = Liabilities + Equity

Liabilities = Assets + Owners Equity

Balance Sheet
Assets are economic resources owned by a
company.
Balance Sheet
Assets are economic resources owned by a
company.
Examples include cash, accounts receivable,
supplies, buildings and equipment.
Balance Sheet
Liabilities are the companys debt or
obligations.
Balance Sheet
Liabilities are the companys debt or
obligations.
Examples are accounts payable, unearned
revenues and bonds payable.
Balance Sheet
Equity is the residual balance. Assets
liabilities = equity. Equity is commonly
called stockholders equity if the business is
a corporation as it represents the financing
provided by the stockholders along with the
earnings from the business not paid out as
dividends.
Balance Sheet
There are two different types of assets
shown on a balance sheet. These are
current assets and non-current assets.
Balance Sheet
There are two different types of assets
shown on a balance sheet. These are
current assets and non-current assets.
Current assets
+ Non-current assets
Total assets
Balance Sheet
Current assets are assets that will be used
or turned into cash within one year.
Balance Sheet
Current assets are assets that will be used
or turned into cash within one year.
Examples include cash, accounts receivable,
inventory, short-term investments, supplies
and prepaids.
Balance Sheet
Non-current assets comprise the remainder
of the assets.
Balance Sheet
Non-current assets comprise the remainder
of the assets.
These include accounts such as: long-term
investments, land, building, equipment and
patents.
Balance Sheet
There are two different types of liabilities
shown on a balance sheet current
liabilities and long-term liabilities.
Balance Sheet
There are two different types of liabilities
shown on a balance sheet current
liabilities and long-term liabilities.
Current liabilities
+ Long-term liabilities
Total liabilities
Balance Sheet
Current liabilities are obligations that will
be paid in cash (or other services) or
satisfied by providing service within the
coming year.
Balance Sheet
Current liabilities are obligations that will
be paid in cash (or other services) or
satisfied by providing service within the
coming year.
Examples include accounts payable, short-
term notes payable, and taxes payable.
Balance Sheet
Long-term liabilities are obligations that
will not be paid or satisfied within the year.
Balance Sheet
Long-term liabilities are obligations that
will not be paid or satisfied within the year.
Examples include mortgage payable and
bonds payable.
Balance Sheet
Stockholders Equity is divided into two
categories: contributed capital and retained
earnings.
Contributed capital
+ Retained earnings
Total stockholders equity
Balance Sheet
Contributed capital is the amount of cash
(or other assets) provided by the
shareholders.
Balance Sheet
Contributed capital is the amount of cash
(or other assets) provided by the
shareholders.
Common Stock and Additional Paid in
Capital are accounts in this section.
Balance Sheet
Retained earnings is the total earnings that
have not been distributed to owners as
dividends.
The Balance Sheet
Current assets
Total assets

Current liabilities
+ Stockholders equity
Total liabilities and
stockholders equity

Balance Sheet
The Balance Sheet must be prepared after
the Statement of Retained Earnings in order
to have calculated the ending balance of
Retained Earnings.
Income
Statement

Net income

Statement of Retained
Earnings
Beginning Retained
Earnings
+ Net income
Dividends
Ending retained earnings
Balance Sheet

Ending Balance
Retained
Earnings
Order of Preparation
Income statementA summary of the revenue and
expenses for a specific period of time.
Statement of retained earnings a summary of the
changes in the retained earnings that have occurred
during a specific period of time.
Balance sheetA list of the assets, liabilities, and
owners equity as of a specific date.
Review of financial statements
Example Problem
Cash 5,000 Sales 100,000
Utility Expense 8,000 Buildings 65,000
Common Stock 45,000 Accounts Payable 12,000
Supplies 4,000 Cost of Goods Sold 58,000
Interest Expense 5,000 Additional Paid in
Capital
20,000
Bonds Payable 40,000 Supplies Expense 3,000
Salaries Expense 16,000 Accounts Receivable 10,000
Inventories 45,000 Retained Earnings 5,000 (beg. bal.)
Income Tax Rate 30%
Step One
Classify the accounts as assets, liabilities,
equity, revenue or expenses.
Assets
Cash 5,000 Sales 100,000
Capital
20,000
Income Tax Rate 30%
Assets, Liabilities,
Cash 5,000 Sales 100,000
Capital
20,000
Income Tax Rate 30%
Assets, Liabilities, Equity
Cash 5,000 Sales 100,000
Capital
20,000
Income Tax Rate 30%
Assets, Liabilities, Equity,
Revenues
Cash 5,000 Sales 100,000
Capital
20,000
Income Tax Rate 30%
Assets, Liabilities, Equity,
Revenues, Expenses
Cash 5,000 Sales 100,000
Capital
20,000
Income Tax Rate 30%
Step Two
Prepare the Income Statement.
Sales revenue
- Cost of goods sold
Gross profit
- Operating expenses
Income from operations
+/- Non-operating items
Income before taxes
- Income taxes
Net income
Income Statement
Sales 100,000
- Cost of Goods Sold -58,000
Gross Margin 42,000
- Operating Expenses -27,000
Income from
Operations
15,000
- Non-operating Items -5,000
Income before Taxes 10,000
- Income Taxes -3,000
Net Income 7,000
Income Statement
Sales 100,000
Gross Margin 42,000
Income from
Operations
15,000
Net Income 7,000
Operating expenses include:

Utility expense 8,000
Salaries expense 16,000
Supplies expense 3,000
Income Statement
Sales 100,000
Gross Margin 42,000
Income from
Operations
15,000
Net Income 7,000
Non-operating items include:

Interest expense 5,000
Income Statement
Sales 100,000
Gross Margin 42,000
Income from
Operations
15,000
Net Income 7,000
Income taxes = Income before
taxes * Income tax rate

10,000 * 30% = 3,000
Step Three
Prepare the Statement of Retained Earnings.
Beg. balance, retained earnings
+ Net income
- Dividends
End. balance, retained earnings
Beginning Balance,
Retained Earnings
5,000
+ Net Income +7,000
- Dividends -0
Ending Balance,
Retained Earnings
12,000
Net Income is brought
forward from the Income
Statement.
Step Four
Prepare the Balance Sheet.
Current assets
Total assets

Current liabilities
+ Stockholders equity
Total liabilities and
stockholders equity

Balance Sheet
Current Assets: Current Liabilities:
Cash 5,000 Accounts Payable 12,000
Accounts Receivable 10,000 Long-term
liabilities:
Inventories 45,000 Bonds Payable 40,000
Supplies 4,000 Stockholders
Equity:
Non-Current
Assets:
Common Stock 45,000
Buildings 65,000 Additional Paid in
Capital
20,000
Retained Earnings

12,000

Total Assets

129,000 Total Liabilities
and Equity

129,000
Balance Sheet
Current Assets: Current Liabilities:
Cash 5,000 Accounts Payable 12,000
Accounts Receivable 10,000 Long-term
liabilities:
Inventories 45,000 Bonds Payable 40,000
Supplies 4,000 Stockholders
Equity:
Non-Current
Assets:
Common Stock 45,000
Buildings 65,000 Additional Paid in
Capital
20,000
Retained Earnings

12,000

Total Assets

129,000 Total Liabilities
and Equity

129,000
End. Bal. is
brought
forward from
the Statement
of Retained
Earnings
Cash Flow Statement
Shareholder value is now widely accepted as an
appropriate standard for performance in US
business. The stock market sends a clear message
that earning per share is not the most important
measure. Now is growth for growths sake. What
matters is long-term cash generation. (Werner &
LeBer, Managing for Shareholder Value--From
Top to Bottom, Harvard Busines Review, Nov.-
Dec. 1989 pp. 52-65.)
Basic Form of Cash Flow Statement
Cash Flow From Operating Activities
Direct method or indirect method (direct requires
also a reconciliation of net income to cash flow
from operating activities)
Cash Flow from investing activities
Cash Flow from financing activities
Total (positive or negative) cash flow is added to
beginning cash balance and should result in ending
cash balance
Flow from Operating Activities
Includes:
Current assets
except Marketable securities and s-term notes
receivable which are investing
Current Liabilities
except s-t notes payable which are financing
Revenue and Expenses (includes interest
expense and revenue, and dividends received)

Flow from Investing Activities
Includes:
Short-term and long-term investments
Short-term and long term notes receivable
Property, Plant and Equipment (depreciation
affects operating activities)
Intangible Assets
Flow from Financing Activities
Includes:
Short-term and long-term loans
Capital Stock and Paid in Capital in excess of
par
Retained earnings (net income aspect is
operating)
Dividends Paid
General Theory
Take revenue or expense account (includes
cash and accrual)
adjust out accrual amounts
Result is net cash in or out.
Too expensive to classify all cash
transactions into operating, financing,
investing activities. Cheaper to use accrual
systems and adjust out accrual information
Operating Activities Indirect Method
Net Income
+ Depreciation exp (noncash exp)
+ Losses from sale of assets
(full amount of sale already included in investing section)
- Gains from sale of assets
(full amount of sale already included in investing section)
- increases in current assets
+ decreases in current assets
+ increases in current liabilities
- decreases in current liabilities
= Net cash from operating activities

Operating Activities Direct Method
+ Cash Received from Customers
- Cash paid for inventory
- Cash paid for operating expenses
- Cash paid for income taxes
- Cash paid for interest
+ Cash received from dividends and interest
= Net cash from operating activities
Cost of Capital?
When we say a firm has a cost of capital of, for
example, 12%, we are saying:
The firm can only have a positive NPV on a project if
return exceeds 12%
The firm must earn 12% just to compensate investors
for the use of their capital in a project
The use of capital in a project must earn 12% or more,
not that it will necessarily cost 12% to borrow funds for
the project
Thus cost of capital depends primarily on the USE
of funds, not the SOURCE of funds
Weighted Average Cost of Capital
A firms overall cost of capital must reflect the
required return on the firms assets as a whole
If a firm uses both debt and equity financing, the
cost of capital must include the cost of each,
weighted to proportion of each (debt and equity)
in the firms capital structure
This is called the Weighted Average Cost of
Capital (WACC)
Cost of Debt
The cost of debt is generally easier to calculate
Equals the current interest cost to borrow new funds
Current interest rates are determined from the going
rate in the financial markets
The market adjusts fixed debt interest rates to the going
rate through setting debt prices at a discount (current
rate > than face rate) or premium (current rate < than
face rate)
Cost of Equity
The Cost of Equity may be derived from the dividend
growth model as follows:
P = D / RE g
Where the price of a security equals its dividend (D)
divided by its return on equity (RE) less its rate of growth
(g). We can invert the variables to find RE as follows:
RE = D / P + g
But this model has drawbacks when considering that some
firms concentrate on growth and do not pay dividends at
all, or only irregularly. Growth rates may also be hard to
estimate. Also this model doesnt adjust for market risk.
Cost of Equity (2):
Therefore many financial managers prefer the security
market line/capital asset pricing model (SML or
CAPM) for estimating the cost of equity:
RE = Rf + E x (RM Rf)
or Return on Equity = Risk free rate + (risk factor x risk
premium)
Advantages of SML: Evaluates risk, applicable to
firms that dont pay dividends
Disadvantages of SML: Need to estimate both Beta
and risk premium (will usually base on past data, not
future projections.)
Weighted Average Cost of
Capital (WACC)
WACC weights the cost of equity and the cost of
debt by the percentage of each used in a firms
capital structure
WACC=(E/ V) x RE + (D/ V) x RD x (1-TC)
(E/V)= Equity % of total value
(D/V)=Debt % of total value
(1-Tc)=After-tax % or reciprocal of corp tax rate Tc.
The after-tax rate must be considered because interest
on corporate debt is deductible
WACC Illustration
ABC Corp has 1.4 million shares common valued at $20
per share =$28 million. Debt has face value of $5 million
and trades at 93% of face ($4.65 million) in the market.
Total market value of both equity + debt thus =$32.65
million. Equity % = .8576 and Debt % = .1424
Risk free rate is 4%, risk premium=7% and ABCs =.74
Return on equity per SML : RE = 4% + (7% x .74)=9.18%
Tax rate is 40% Current yield on market debt is 11%
WACC = (E/V) x RE + (D/V) x RD x (1-Tc)
= .8576 x .0918 + (.1424 x .11 x .60)
= .088126 or 8.81%
Final notes on WACC
WACC should be based on market rates and
valuation, not on book values of debt or equity.
Book values may not reflect the current
marketplace
WACC will reflect what a firm needs to earn on a
new investment. But the new investment should
also reflect a risk level similar to the firms Beta
used to calculate the firms RE.
In the case of ABC Co., the relatively low WACC of
8.81% reflects ABCs =.74. A riskier investment
should reflect a higher interest rate.
Valuation Measurement and
Value Creation

Valuation Situations
We encounter valuation in many situations:
Mergers & Acquisitions
Leveraged Buy-outs (LBOs & MBOs)
Sell-offs, spin-offs, divestitures
Investors buying a minority interest in company
Initial public offerings

How do we measure value?
Why do we observe these situations? How can
managers create value?
Business Valuation Techniques
Discounted cash flow (DCF) approaches
Dividend discount model (DDM)
Free cash flows to equity model (FCFE - direct approach)
Free cash flows to the firm model (FCFF- indirect approach)

Relative valuation approaches
P/E (capitalization of earnings)
Enterprise Value/EBITDA
Other: P/CF, P/B, P/S

Mergers and acquisitions
Control transaction based models (e.g. value based on acquisition
premia of similar transactions)
Discounted Cash Flow Valuation
What cash flow to discount?
Investors in stock receive dividends, or periodic cash
distributions from the firm, and capital gains on re-sale
of stock in future
If investor buys and holds stock forever, all they receive
are dividends
In dividend discount model (DDM), analysts forecast
future dividends for a company and discount at the
required equity return

Dividend Discount Models (DDM)
The value of equity (V
e
) is the present value of the
(expected) future stream of dividends
V
e
= Div
1
/(1+r) + Div
1
(1+g
2
)/(1+r)
2
+
Div
1
(1+g
2
)(1+g
3
)/(1+r)
3
+...

If growth is constant (g
2
= g
3
= . . . = g) , the
valuation formula reduces to:
V
e
= Div
1
/(r - g)
Some estimation problems:
firms may not (currently) pay dividends
dividend payments may be managed (e.g., for stability)
Dividends: The Stability Factor
Factors that influence
dividends:

Desire for stability
Future investment
needs
Tax factors
Signaling prerogatives
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
1981 1984 1987 1990 1993
No Change
Increase
Decrease

Dividend changes: Publicly traded U.S. Firms
Source: A. Damodaran, Investment Valuation, Wiley, 1997
Discounted Free Cash Flow Equity (FCFE)
Approach (Direct Method)
Buying equity of firm is buying future stream of free cash flows
(available, not just paid to common as dividends) to equity holders
(FCFE)

FCFE is residual cash flows left to equity holders after:
meeting interest/principal payments
providing for capital expenditures and working capital to maintain
and create new assets for growth

FCFE = Net Income + Non-cash Expenses - Cap. Exp.
- Increase in WC - Princ. Payments

Problem: Calculating cash flows related to debt (interest/ principal) &
other obligations is often difficult!
Valuation: Back to First Principles
Value of the firm =
value of fixed claims (debt) + value of equity

How do managers add to equity value?
By taking on projects with positive net present value (NPV)
Equity value =
equity capital provided + NPV of future projects

Note: Market to book ratio (or Tobins Q
ratio) >1 if market expects firm to take on
positive NPV projects (i.e. firm has significant
growth opportunities)
Valuation: First Principles
Total value of the firm

= debt capital provided + equity capital provided
+ NPV of all future projects project for the firm

= uninvested capital +
present value of cash flows from all future
projects for the firm

Note: This recognizes that not all capital may be
currently used to invest in projects
Discounted Free Cash Flow to the Firm
(FCFF) Approach (Indirect Approach)
Identify cash flows available to all stakeholders
Compute present value of cash flows
Discount the cash flows at the firms weighted average cost of
capital (WACC)
The present value of future cash flows is referred
to as:
Value of the firms invested capital, or
Value of operating assets or Total Enterprise Value (TEV)
The DCFF Valuation Process
Value of all the firms assets (or value of the
firm)
= V
firm
= TEV + the value of uninvested capital
Uninvested capital includes:
assets not required (redundant assets)
excess cash (not needed for day-to-day operations)
Value of the firms equity
= V
equity
= V
firm
- V
debt

where V
debt
is value of fixed obligations (primarily debt)
Total Enterprise Value (TEV)
For most firms, the most significant item of
uninvested capital is cash

V
firm
= V
equity
+ V
debt
= TEV + cash

TEV = V
equity
+ V
debt
- cash

TEV = V
equity
+ Net debt

where Net debt is debt - cash (note: this assumes all
cash is excess)
Measuring Free Cash Flows to the Firm (FCFF)
Free Cash Flow to the Firm (FCFF) represents cash flows to which all
stakeholders make claim

FCFF = EBIT (1 - tax rate)
+ Depreciation and amortization (non cash items)
- Capital Expenditures
- Increase in Working Capital

What is working capital?
Non-cash current assets - non-interest bearing current liabilities
(e.g. A/P & accrued liab.)
Working Capital vs. Permanent Financing
Short-term
assets
Short- term
liabilities
Permanent
Capital
Long-term
assets
Permanent
Capital
Operating
assets
Working
capital
Permanent capital may include current items such as bank loans
if debt is likely to remain on the books

Key: Treat items as either working capital or permanent capital but
not both
Uninvested
capital
FCFF vs. Accounting Cash Flows
Income Statement, Hudsons Bay
($millions, FYE Jan 1999)

Sales $7,075
Cost of Goods Sold $6,719
EBITDA $ 356
Depreciation $ 169
EBIT $ 187
Interest Expense $ 97
Income Taxes $ 50
Net Income $ 40
Dividends $ 53

Cash Flow Statement, Hudsons Bay,
($millions, FYE Jan 1999)

Cash flow from operations
Net Income $ 40
Non-cash expenses $ 169
Changes in WC ($116)
Cash provided (used) by investments
Additions to P,P & E ($719)
Cash provided (used) by financing
Additions (reductions) to debt $ 259
Additions (reductions) to equity $ 356
Dividends ($ 53)
Overall Net Cash Flows ($ 64)

Hudsons Bay FCFF = 187 * (1- 0.44) + 169 - 719 - 116 = ($ 561)

FCFF Definition Issues
Why is FCFF different from accounting cash
flows?

Accounting cash flows include interest paid
We want to identify cash flows before they are allocated to
claimholders
FCFF also appears to miss tax savings due to
debt
Key: these tax savings are accounted for in WACC
An Example
$1 million capital required to start firm

Capital structure:
20% debt (10% pre-tax required return): $200,000
80% equity (15% required return): $800,000

tax rate is 40%
firm expects to generate 220,000 EBIT in perpetuity (all earnings
are paid as dividends)
future capital expenditures just offset depreciation
no future additional working capital investments are required

What should be the value of this firm?
An Example, continued
Let us look first at how the EBIT is distributed to the
various claimants:
EBIT $220,000
Interest (20,000) $200,000*10%
EBT $200,000
tax (80,000) 40% rate
EAT $120,000

Div. to common $120,000

Note: The dividend to equity equals 15% of equity
capital

The firm here generates a cash flow that is just
enough to deliver the returns required by the
different claimants.
i.e. the NPV of the firms projects = 0
Another way to see this:
WACC = 0.2 * 10% * (1 0.4) + 0.8 * 15% = 13.2%
Pre-tax WACC = 13.2% / (1 0.4) = 22%
EBIT / capital is also 22%, so NPV of future projects for this
firm is zero
From first principles, the value of the firm should
equal the invested capital, or $1,000,000
Now consider FCFF valuation of this firm
FCFF = EBIT * (1-t) = $220,000 * (1 0.4) = $132,000
Value = 132,000 / 0.132 = $1,000,000

Note: we could have accounted for taxes in cash
flow and not WACC
WACC without tax adjustment = 14%
Adjusted FCFF = EBIT actual taxes
= $220,000 80,000 = $140,000
Value = $140,000 / 0.14 = $1,000,000

Key: account for tax benefit, but only once (no
double counting)!
Two Stage FCFF Valuation
Impossible to forecast cash flow indefinitely
into the future with accuracy
Typical solution: break future into stages
Stage 1 : firm experiences high growth
Sources of extraordinary growth:
product segmentation
low cost producer
Period of extraordinary growth:
based on competitive analysis / industry analysis
Stage 2: firm experiences stable growth
Stage 1 Valuation
Forecast annual FCFF as far as firm expects
to experience extraordinary growth
generally sales driven forecasts based on historical growth
rates or analyst forecasts
EBIT, capital expenditures, working capital given as a
percentage of sales

Discount FCFF at the firms WACC (k
c
)

FCFF
1

+
FCFF
2 + . . . +
FCFF
t

1+k
c
(1+k
c
)
2
(1+k
c
)
t

VALUE
1
=
Stage 2 Valuation
Start with last FCFF in Stage 1
Assume that cash flow will grow at constant
rate in perpetuity
Initial FCFF of Stage 2 may need adjustment if last cash flow
of Stage 1 is unusual
spike in sales or other items
capital expenditures should be close to depreciation

Value 1 year before Stage 2 begins =
FCFF
t
* (1+g)
K
c
- g
Stage 2 Valuation
Present value of Stage 2 cash flows (Terminal Value or
TV):

Key issue in implementation: Terminal growth (g)
rate of stable growth in the economy (real rate of return ~1-2% plus
inflation)

TEV = VALUE
t
+ TV
1
(1+k
c
)
t

x
TV =
FCFF
t
* (1+g)
K
c
- g
Discounted FCFF Example
Assumptions

Year EBIT Dep Cap Ex W/C
Change
1 40 4 6 2
2 50 5 7 3
3 60 6 8 4

Tax rate = 40%
k
c
= 10%
V
debt
= value of debt = $100
Growth (g) of FCFFs beyond year 3 = 3%
Discounted FCFF Example (contd)
FCFF = EBIT*(1-t) + Dep - CapEx - Increase in
WC

Year 1 FCFF = 40*(1 - 0.4) + 4 - 6 - 2 = 20
Year 2 FCFF = 50*(1 - 0.4) + 5 - 7 - 3 = 25
Year 3 FCFF = 60*(1 - 0.4) + 6 - 8 - 4 = 30
Discounted FCFF Example (contd)
20 25 30 30*(1+g) 30*(1+g)
2

| | | | | |
t=0 1 2 3 4 5
P = V
firm

30*(1+g)/(k
c
-g)

TEV = 20/(1+k
c
) + 25/(1+k
c
)
2
+ 30/(1+k
c
)
3
+
[30*(1+g)/(k
c
-g)]/(1+k
c
)
3

Mergers & Acquisitions
MERGER
STATUTORY
MERGER
SUBSIDARY
MERGER
CONSOLIDATION
MERGER
ACQUISITIONS
ACQUISITION- Purchase of some portion of
one company by another
- Purchase of assets
- Purchase of Subsidiaries

MERGER- Full Absorption/Acquisition of one
company by another
~
=
Takeovers/Hostile Transactions
A+d= A
d stops to exist
A+d= A + d
d becomes a
subsidiary d of A
A+B= C
Both Companies A
and B ceases to
legally exist and
forms C
A- A big Company
B- Similar in size and brand as that of A
d- A small company
d- Subsidiary to A
C- Company bigger than A and B

Objectives
Drop Down Effect of Global Restructuring
Burroughs Wellcome (India) Ltd with GlaxoSmithkline Pharmaceuticals Ltd

Reduce the number of Companies in Group
Philips Medical System India Private Ltd & Philips Software Centre Private Ltd with
Philips India Ltd

Backwards & Forward Integration
Kochi Refineries Ltd with Bharat Petroleum Corporation Ltd

Expansion
Tata Chemicals Ltd. & Hind Lever Chemicals Ltd.
Focus on Core Activities
Demerger of cement business of Larsen &Toubro Ltd into Ultra Tech CemCo Ltd
(Aditya Birla Group Company)
Curtail Competition
Hindustan Lever Ltd., merged itself with TOMCO, Doom Dooma Tea, Kwality, Dollops
from Cadbury, Kissan from UB, Lakme
Types of Merger
Horizontal - Merger between business competitors engaged in same industry.
For e.g. TOMCO ( Tata Oil Mills) & HLL, Vodafone acquired Mannessman AG in
2000, Vodafone acquired Hutch in 2006
Vertical - Merger of two companies in related lines of business. For e.g. Reliance
Petro Ltd. & Reliance Industries Ltd
Conglomerate - Merger of companies in different industries. For e.g. GE has
acquired many companies in different spaces
Valuation Methods
ASSET BASED METHOD
Book Value (NAV)
Replacement Value/ Realizable Value
EARNING BASED METHODS
Past Earnings - Earnings Capitalisation Method or Yield Method (PECV)
Future Earnings - Discounted Cash Flow (DCF) Method
MARKET APPROACH
Market Price
Market Comparables
Selection of Methods
History and nature of business.
Economic outlook for the Company and the Industry in which it operates.
Prior Sale of the firms equity
Market Value of other firms which are traded actively in the free & open market
Decisions of Indian Courts in the past
It is fair to use combination of three well known methods - asset value, yield value &
market value {Hindustan Lever Employees Union Vs. HLL (1995) 83 Com. Case 30 AIR
1995 SC 470}
Net Assets Method
Assets at historical cost or replacement cost on valuation date considered
It is usual to ignore market value of the operating assets for the simple reason that under the going
concern valuation, it is not the intention to sell the assets on a piece meal basis.

Net Assets Value = Total Assets (excluding Miscellaneous Expenditure & Debit balance of Profit &
Loss account) Total Liabilities
Or
Net Assets Value = Share Capital + Reserves (excluding revaluation reserves) Miscellaneous
Expenditure Debit Balance of Profit & Loss Account

Outstanding liabilities deducted
Following adjustments may be called for:
Accounting Policies
Contingent Liabilities
Sales Tax Deferment Loan
Investments & Surplus Assets
Inventory & Debtors
Contingent Assets
Preference Shares
Earnings Based Methods
Earnings Capitalization method / Yield method - determination of 3 parameters :
Firstly; the future maintainable profits
Secondly; the appropriate tax rate
Thirdly; the Capitalization rate / Price Earning Multiple.
Value determined by capitalizing future Maintainable PAT by the capitalization rate and
making adjustments for Non Operating Assets & Contingent Liabilities
Can be based on projections or past performance
Non-recurring and extraordinary items to be removed
Profits of various years averaged
Weightages may be assigned; generally current years profit assigned highest weight
Maintainable profit after tax arrived at after applying effective tax rate
Discounted Cash Flow
Cash is King!!!
Values a business based on the expected Cash Flows over a given period of time
Involves determination of discount factor and growth rate for perpetuity
Value of business is aggregate of discounted value of the cash flows for the explicit
period and perpetuity
Free Cash Flow (FCF)
FCF to Firm
FCF to Equity
Steps involved:
Present Value of future free cash flows for explicit period & perpetuity value
Appropriate discount factor - Weighted Average Cost of Capital (WACC)
Growth Rate for Perpetuity
Capitalised Value of Perpetuity
Enterprise Value = Aggregate DCF for explicit period + Perpetuity Value
Equity Value = Enterprise Value - Debts
Market Price Method

Evaluates the value on the basis of prices quoted on the stock exchange
Thinly traded / Dormant Scrip Low Floating Stock
Significant and Unusual fluctuations in the Market Price
Weighted Average of quoted price for past 6 months
Regulatory bodies often consider market value as important basis Preferential
allotment, Buyback, Takeover Code
Market Comparables
Generally applied in case of unlisted entities
Estimates value by relating an element with underlying element of similar listed
companies.
Based on market multiples of Comparable Companies
Book Value Multiples
Industry Specific Multiples
Multiples from Recent M&A Transactions
Issues
Value of surplus assets.
Replacement value - reliance on valuers report
Investments/marketable securities
Contingent liabilities
Dividend on Preference shares
Treatment of extraordinary items
Unusual fluctuation in market prices
Review of projections - Underlying assumptions
Findings of due diligence reviews
Dilution of equity- ESOP, Convertible instruments, warrants
Tax Benefits e.g. section 80IA, Sales Tax Exemption, etc.
Assigning weightages to the values arrived at per different methods
Joint Report - Consensus for exchange ratio
Important Formulae in M&A
Company A ( Acquirer) merges/acquires Company B ( Target)
Value of Combined Company = Value of A+ Value of B+ Synergies- Cash Paid for the
transaction
Price per share of the combined company = (Value of Combined company/ Total
No. of shares of the combined company)
Takeover Premium = Price of Combined company post merger- Price of target pre
merger
Gain to the target = Takeover Premium
Gain to the Acquirer = Synergy- Takeover Premium
Exchange/Swap Ratio - How it works?
Method Rs. Per Share Weight Product
Co. A Co. B Co. A Co. B
NAV 10 8 1 10 8
Earnings 20 32 2 40 64
Market 25 24 2 50 48
5 100 120
Fair Value 20 24
Ratio : For every 5 shares held in Company B , 6 shares of Company A
Activity Chart for Merger
Preliminary discussions between the management of two companies.
Appointment of Valuers & Solicitors
Obtain Draft Scheme of Amalgamation & Valuers Report
Approve the ratio in Board Meeting
File draft scheme with Stock Exchanges & get their approval.
File application with high court, get direction for calling EGM.
Send notices to Shareholders, Creditors, etc.
Hold EGM
File Chairmans report with High Court
Obtain liquidators report for Transferor Company
Receive Courts order sanctioning the scheme.
File Courts order with ROC
Fixing of record date for allotment of shares.
Normally whole process takes about 7 to 8 months.

Thank You for your patience.

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Financial Modelling in Excel

Indian Institute of Quantitative Finance

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