PROJECT REPORT SUBMITTED TOWARDS THE PARTIAL FULFILLMENT OF

BACHELOR OF COMMERCE HONOURS

PROJECT REPORT

ON

FINANCIAL MODELLING
BATCH: 2016-2018

Submitted By: Project Guide-

GUNIKA SAHNI Mr. PRADEEP KUMAR

Enrollment No- 60620688816 (Assistant Professor)

TRINITY INSTITUTE OF PROFESSIONAL STUDIES

Affiliated to Guru Gobind Singh Indraprastha University, New Delhi

 DECLARATION

I hereby declare that the following documented project report on “Financial Modeling” is an
original and authentic work done by me for the partial fulfillment of Bachelor of Commerce
{B.com (hons)}.

I hereby declare that all the Endeavour put in the fulfillment of the task and genuine and original
to the best of my knowledge & I have not submitted it earlier elsewhere.

Signature:

GUNIKA SAHNI

B.COM (H), SECTION-B, 1st SHIFT

60620688816
 ACKNOWLEDGEMENT

It is in particular that I am acknowledging my sincere feeling towards my mentors who

graciously gave me their time and expertise.

They have provided me with the valuable guidance sustained and friendly approach it would
have been difficult to achieve the results in such a short span of time without their help.

I deem it my duty to record my gratitude towards my internal project supervisor Mr. Pradeep
Kumar who devoted his precious time to interact, guide and gave me the right approach to
accomplish the task and also helped me to enhance my knowledge and understanding of the
project.

Signature:

GUNIKA SAHNI

B.COM (H), SECTION-B, 1st SHIFT

60620688816
 TABLE OF CONTENTS
PARTICULARS PAGE NO.
1. UNIT 1
1.1 Introduction to MS Excel
1.2 Command in MS Excel
1.3 Wrap Text
1.4 Filtering and Sorting
1.5 Merger and Center
1.6 Find and Select
1.7Conditional Formatting
1.8 Pivot Chart and Pivot Table
1.9 Formulas
1.10 What if Analysis
1.11 Macros and Problem Solver
2. UNIT 2
2.1 Financial Modeling (Advanced Excel Tools)
2.2 Filling Historical Data
2.3 Building a Template
2.4 Identifying Assumptions and Drivers
2.5 Forecasting and Building Various Schedules and Financial Statement
2.6 Various Approaches to Valuation
2.7 Ratio Analysis
2.8 Sensitivity Analysis
2.9 Probabilistic Analysis of Best and Worst Case Scenario
3. UNIT 3
3.1 Structured Model with a Menu and Accounting Statements
3.2 Key Financial Ratios
3.3 Time Value of Money
3.4 Capital Budgeting Model
3.5 Market Based Methods
UNIT-1

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1.1 INTRODUCTION TO EXCEL

1.1.1 MICROSOFT EXCEL

Microsoft Excel is a software program produced by Microsoft that allows users to organize,
format and calculate data with formulas using a spreadsheet system.

1.1.2 SPREADSHEET
A MS Excel Spreadsheet is basically a worksheet which is divided into rows and columns to
store data related to business inventories, income and expenses, debits and credits. You can use it
to organize your data into rows and columns. You can also use it to perform mathematical
calculations quickly

1.1.3 WORKBOOK
A Microsoft Office Excel workbook is a file that contains one or more worksheets that you can
use to organize various kinds of related information. To create a new workbook, you can open a
blank workbook. You can also base a new workbook on an existing workbook, the default
workbook template, or any other template.

1.1.4 ACTIVE CELL

An active cell refers to a cell in Excel spreadsheet that is currently selected by clicking mouse
pointer or keyboard keys. Only one cell can be active cell at a time. An active cell is bounded by
a heavy border around it.

1.1.5 CELL ADDRESS

A sell address is a combination of a letter and a number that specifies the column and row in
which a cell is located on a spreadsheet.

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1.1.6 MICROSOFT OFFICE BUTTON
The Microsoft Office button is used exclusively in the Microsoft Office 2007 versions of the
following programs: Word, Excel, PowerPoint, Access, and Outlook (in the composing and
reading windows). It is not used in any prior or subsequent version of Microsoft Office. Any
guidance containing references to the Microsoft Office button applies only to Office 2007.

1.1.7 QUICK ACCESS TOOLBAR AND RIBBON

By default, the Quick Access Toolbar, located above the ribbon, contains the Save, Undo and
Redo button. If you use an Excel command frequently, you can add it to the Quick Access
Toolbar. You can even add commands to the Quick Access Toolbar that are not in the ribbon.

The Ribbon is the name given to the row of tabs and buttons you see at the top of Excel. The
Ribbon's tabs and buttons bring your favorite commands into the open by showing multiple
commands grouped in specific categories.

1.1.8 COLUMN-
A column runs vertically in the grid layout of a worksheet. Vertical columns are numbered with
alphabetic values such as A, B, C. Horizontal rows are numbered with numeric values such 1, 2,
3.

1.1.9 ROW-
In Microsoft Excel, a row runs horizontally in the grid layout of a worksheet. Horizontal rows
are numbered with numeric values such as 1, 2, 3. Vertical columns are numbered with
alphabetic values such A, B, C.

1.1.10 RANGE-
In Microsoft Excel, a range is a collection of cells. A range can be 2 or more cells and those cells
don't necessarily have to be adjacent to each other. Let's look at some examples to quickly
demonstrate the different types of ranges.

Vertical Range-
This vertical range is A2:A5. In this example, if you had selected the entire column A, the range
would be A:A.

Horizontal Range-
This horizontal range is A2:C2. In this example, if you selected the entire row 2, the range would
have be 2:2.

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Mixed Range-
This mixed range is A2:C5. This is a collection of cells that can be from multiple rows and
columns.

Multiple Selection Range-

This multiple selection range is A2:A3,B4:B5. This is a collection of cells that does not have to
be adjacent.

1.1.11 HOW TO INSERT VALUE-

For inserting value/data, just activate the cell type text or number and press enter or Navigation
keys.

1.1.12 HOW TO DELETE-

Select the cells, rows, or columns you want to delete. Click the drop-down button attached to the
Delete button in the Cells group of the Home tab. Click Delete Cells on the drop-down menu.

1.1.13 HOW TO COPY-

To copy and paste, just select the cells you want to copy. Choose copy option after right click or
press Control + C.

1.1.14 HOW TO PASTE-

Select the cell where you need to paste this copied content. Right click and select paste option or
press Control + V.

1.1.15 HOW TO CUT-

Select the cell you want to cut from the content. Right click and select the cut option or press
control + X.

1.1.16 HOW TO EDIT DATA-

You can edit the contents of a cell directly in the cell. You can also edit the contents of a cell by
typing in the formula bar. When you edit the contents of a cell, Excel is operating in Edit mode.
Some Excel features work differently or are unavailable in Edit mode. When Excel is in Edit
mode, the word EDIT appears in the lower-left corner of the Excel program window.

1.1.17 HOW TO INSERT COMMENT-

You can add comments to cells. When a cell has a comment, an indicator appears in the corner of
the cell. When you rest the pointer on the cell, the comment appears.

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1.1.18 HOW TO EDIT COMMENT-
1. Select the cell containing the comment you want to edit.
2. Right-click on the selected cell and select Edit Comment in the pop-up menu.

1.1.19 HOW TO ADD A NEW SHEET-

Clicking the add worksheet button near the worksheet tabs or to insert a new sheet into the
middle of your list of worksheets, click Insert in the Home tab of the Ribbon, and select Insert
Sheet. This will create a new worksheet to the left of the sheet that you’re currently viewing.
You can also insert a new worksheet by right-clicking on any worksheet tab and selecting Insert.

1.1.20 HOW TO RENAME A SHEET-

You can rename a worksheet by right clicking on the worksheet tab and selecting Rename.

1.1.21 HOW TO DELETE A SHEET-

To delete a worksheet, right-click on the name of the sheet and select Delete.

1.1.22 HOW TO HIDE A SHEET-

Click Home > Format. Under Visibility, click Hide & Unhide, and then click Hide Sheet.

1.1.23 HOW TO MOVE/COPY A SHEET-

TO MOVE- Select the worksheet tab, and drag it to where you want it.

 TO COPY- Press CTRL and drag the worksheet tab to the tab location you want OR
 Right click on the worksheet tab and select Move or Copy.
 Select the Create a copy checkbox.
 Under Before sheet, select where you want to place the copy.
 Select OK.

1.1.24 HOW TO CHANGE TAB COLOUR-

Right-click the worksheet tab whose color you want to change. Choose Tab Color, and then
select the color you want.

1.1.25 HOW TO DRAW BORDERS-

On a worksheet, select the cell or range of cells that you want to add a border to, change the
border style on, or remove a border from. On the Home tab, in the Font group, do one of the
following: To apply a new or different border style, click the arrow next to Borders , and then
click a border style.

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1.1.26 HOW TO DO PASTE SPECIAL-
If you want to paste only a specific aspect of the copied data like its formatting or value, you
would use one of the Paste Special options. After you've copied the data, press Ctrl+Alt+V, or
Alt+E+S to open the Paste Special dialogue.You can also click Home > Paste > Paste Special.

1.1.27 WHAT IS TRANSPOSE-

The Microsoft Excel TRANSPOSE function returns a transposed range of cells. For example, a
horizontal range of cells is returned if a vertical range is entered as a parameter. Or a vertical
range of cells is returned if a horizontal range of cells is entered as a parameter.

1.2 COMMANDS IN MS EXCEL

1. CUT (CTRL + X): The cut command removes the selected data from its original position.

2. COPY (CTRL + C): The copy command creates a duplicate, the selected data is kept in a
temporary storage tool called the clipboard.

3. PASTE (CTRL + V): The data in the clipboard that was either cut or copied is later inserted
in the position where the paste command is issued.

4. BOLD (CTRL + B): Renders the text with a strong emphasis which is usually heavier than
surrounding text.

5. ITALIC (CTRL + I): Italicizes the selected text which usually appears slanted to the right

6. UNDERLINE (CTRL + U): Adds a line under the selected text.

7. BACKGROUND COLOURS: Enables you to fill color in the selected cells.

1.3 WRAP TEXT

Wrap Text is a feature that wraps the text within a cell.

Q. Use the Wrap Text function

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1. In a worksheet, select the cells that you want to format.

2. On the Home tab, in the Alignment group, click Wrap Text. Data in the cell wraps to fit the
column width, so if you change the column width, data wrapping adjusts automatically

Example: We used the ‘Wrap Text’ function to wrap the text ‘Financial Modeling’ in one cell

1.4 FILTERING AND SORTING

Sorting is a common spreadsheet task that allows you to easily reorder your data. The most
common type of sorting is alphabetical ordering, which you can do in ascending or descending
order

Q. Use the sorting and filtering functions on the given data

7
Let us take the above example for Sorting

1. Select a cell in the column you want to sort (a column with numbers).

2. Click the Sort & Filter command in the Editing group on the Home tab.

3. Select From Largest to Smallest. Now the information is organized from the largest to
smallest.

Filtering data in a spreadsheet means to set conditions so that only certain data is displayed. It is
done to make it easier to focus on specific information in a large database or table of data.

8
Above is the Example for Filtering

1. Click the Filter command on the Data tab. Drop-down arrows will appear beside each column
heading and then click the drop-down arrow next to the heading you would like to filter.

2. First uncheck Select All, choose the value you want to filter (in this case 100) and then click
OK. All other data will be filtered, or hidden, and only the data related to the value 100 is visible.

1.5 MERGER AND CENTER

Merging cells is often used when a title is to be centered over a particular section of a
spreadsheet. When a group of cells is merged, only the text in the upper-leftmost box is
preserved

Q. Use the Merger and Center functions

9
On the Home tab, in the Alignment group, click Merge and Center. The cells will be merged in a
row or column, and the cell contents will be centered in the merged cell. To merge cells without
centering, click the arrow next to Merge and Center, and then click Merge Across or Merge
Cells.

In the Example above we will merge D1 and E1 and the word ‘June’ will be placed in the center
as shown below

1. Select D1 and E1 cells.

2. Choose the ‘Merge and Center’ function.

3. D1 and E1 merge into a single cell with the word ‘June’ being placed in the center.

4. To unmerge the merged cell, select the merged cell and choose the ‘unmerge cells’ option.

1.6 FIND AND SELECT

MS Excel provides you the flexibility to use ‘Find and Select’ features to find specified text and
replace it with your desired text

Q. Use the Find and Select function to:-

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a) To find the value 50000

1. We choose the ‘Find’ function

2. Fill in the value 50000 in the field of ‘Find what’

3. Click on ‘Find All’ and it shows all the cells which have the value 50000 in them.

b) To replace the value 50000 with 35000

1. Select the ‘Replace’ function and fill 35000 in the field ‘Replace With’

2. Clicking ‘Replace All’ will replace every cell with value 50000 with 35000.

11
3. Clicking only ‘Replace’ will replace 50000 with 35000 of the selected cell.

1.7 CONDITIONAL FORMATTING

Conditional Formatting (CF) is a tool that allows you to apply formats to a cell or range of cells,
and have that formatting change depending on the value of the cell or the value of a formula.

1. Select the cells which you want to format and choose the ‘Conditional Formatting’.

2. Select the following:-

Q. Use Conditional Formatting

A. Greater than (Example 30000) B. Data Bars

C. Icon Sets D. Color Scales

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1.8 PIVOT TABLE AND PIVOT CHART-
A pivot table is a program tool that allows you to reorganize and summarize selected columns
and rows of data in a spreadsheet or database table to obtain a desired report. A pivot chart is the
visual representation of a pivot table in Excel.

Q. Create a Pivot Table and Pivot Chart

A B C
1000 3000 4000
2000 5000 1000
8000 1000 7000

1. Click a cell in the source data or table range.

2. Go to Insert > Tables > Recommended PivotTable.

3. Excel analyzes your data and presents you with several options

4. Select the PivotTable that looks best to you and press OK

1.9 FORMULAES-
1.9.1 SUM-

13
Calculate the total number of chairs made using the SUM Function-

Select the SUM Function

Select all the values under chairs columns to get the total number of chairs made

1.9.2 AVERAGE-
Calculate Average of marks scored by students by using the AVERAGE Function-

Select the AVERAGE Function

Select all the values under marks column to get the average of all marks

1.9.3 COUNT-
To count the number of students using the COUNT Function-

Select the COUNT Function

14
Select all the values under the Students Column and this function will tell about the number of
students

1.9.4 COUNTA-
It counts cells that contains numbers, texts, logical values, error values and empty text. It will
also count hard-coded values.

Select COUNTA Function

Select all the values and this function will count all kind of numbers, texts etc. And does not
count empty cells.

1.9.5 COUNTIF-

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Microsoft Excel COUNTIF function counts the number of cells in a range, that meets a given
criteria-
Find the number of students with the name ADITYA among the various students-

1. Select the COUNTIF Function from Statistical Functions

2. Select the Range and the Criteria (Aditya)

There are 3 students whose name is Aditya

1.9.6 CONCATENATE-
CONCATENATE function allows you to join 2 or more strings together. The CONCATENATE
function is a built-in function in Excel that is categorized as a String/Text function. It can be used
as a worksheet function (WS) in Excel. As a worksheet function, the CONCATENATE function
can be entered as part of a formula in a cell of a worksheet.

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1.9.7- SUM AS RUNNING TOOL-
You can use a running total to watch the values of items in cells add up as you enter new items
and values over time.

1.9.8 PERCENTAGE-
To get percentage of marks obtained of Student A

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1.9.9 IF FUNCTION-
The IF function can perform a logical test and return one value for a TRUE result, and another
for a FALSE result.

1.9.10 VLOOKUP-
When the VLOOKUP function is called, Excel searches for a lookup value in the leftmost
column of a section of your spreadsheet called the table array. The function returns another value
in the same row, defined by the column index number.

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1.9.11 HLOOKUP-

1.9.12 SQRT-
The Microsoft Excel SQRT function returns the square root of a number. The SQRT function is
a built-in function in Excel that is categorized as a Math/Trig Function. It can be used as a
worksheet function (WS) in Excel. As a worksheet function, the SQRT function can be entered
as part of a formula in a cell of a worksheet.

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1.9.13 ABS-
The Microsoft Excel ABS function returns the absolute value of a number. The ABS function is
a built-in function in Excel that is categorized as a Math/Trig Function.

1.9.14 INT-
The Excel INT function returns the integer part of a decimal number by rounding down to the
integer. Note the INT function rounds down, so negative numbers become more negative. For
example, while INT(10.8) returns 10, INT(-10.8) returns -11.

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1.9.15 ROUND-
Round works by rounding numbers 1-4 down, and rounding numbers 5-9 up. The ROUND
function rounds numbers to a specified level of precision. It can round to the right or left of the
decimal point. If numdigits > 0, number is rounded to the specified number of decimal places to
the right of the decimal point.

1.10 WHAT IF ANALYSIS

What-If Analysis is the process of changing the values in cells to see how those changes will
affect the outcome of formulas on the worksheet. Goal Seek is a process of calculating a value
by performing what-if analysis on a given set of values. Goal Seek determines input values
needed to achieve a specific goal. A Scenario is a set of values that Excel saves and can

21
substitute automatically in cells on a worksheet. You can create and save different groups of
values on a worksheet and then switch to any of these new scenarios to view different results.

Q. Units produced- 50 units, Cost Price- Rs 20, Sales price- Rs 40. Calculate Total Cost,
Total Sales and Profit. For how much should the company sell the product to earn a profit
of Rs 5000

By using ‘Goal Seek’ we see that the company must sell its product for Rs 120/unit to earn
the required profit of Rs. 5000

We take a scenario when the company is able to reduce its cost by 500 then the profit
increases to Rs. 1500 from Rs. 1000.

1.11. MACROS AND PROBLEM SOLVER

A macro is an automated input sequence that imitates keystrokes or mouse actions. A macro is
typically used to replace a repetitive series of keyboard and mouse actions and are common in
spreadsheet and word processing applications like MS Excel and MS Word.

Q. Use option macro and solve the following:

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Opening Stock Rs 20,000, Closing Stock Rs 10,000, Purchases Rs 50,000, Wages Rs 3,000,
Carriage Inward Rs 2,000 and Freight Outward Rs 5,000. Calculate Stock Turnover Ratio.

1. Select the Macro function and start recording

2. Then use the required formula functions to calculate the Stock Turnover Ratio.

3. Then stop the recording and we can see that Excel has recorded our steps so that next time
instead of doing the calculations manually we can simply use the recorded steps

Solver is part of a suite of commands. With Solver, you can find an optimal (maximum or
minimum) value for a formula in one cell called the objective cell subject to constraints, or
limits, on the values of other formula cells on a worksheet.

Q. Using solver Calculate

Demand=30 units, Retail price= Rs.100/unit, Unit cost=Rs.40/unit and hours required to
produce 1 unit= 1 hour. Assume company is currently producing 30 units. Calculate Total
cost, Total Hours and Total Profit. Can the firm earn more profit with following

a) Cost should not exceed 2000

b) Total Hours should not exceed 400

c) Number of units produced should be higher than no. of unit demanded

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1. Open the solver and select the target and changing cells

2. Add the give constraints

3. Click the ‘Solve’ option

4. Solver then provides with a solution

With Following Constraints we see that the Solver gives us a solution that the firm should
now produce 50 units (20 units more) in order to earn a maximum profit of Rs. 3000. Time
taken also increases to 50 hours.

1.12 COLUMN CHART-

Column charts are used to compare values across categories by using vertical bars.

To create a column chart, execute the following steps.

Select the range and click on insert and then on column chart. After this column chart will
display on the screen.

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1.13 DROP DOWN LIST-
1. Create the list in cells A1:A4. Similarly, you can enter the items in a single row, such as
A1:D1.
2. Select cell E3. (You can position the drop-down list in most any cell or even multiple
cells.)
3. Choose Validation from the Data menu.
4. Choose List from the Allow option's drop-down list. (See, they're everywhere.)
5. Click the Source control and drag to highlight the cells A1:A4. Alternately, simply enter
the reference (=$A$1:$A$4).
6. Make sure the In-Cell Dropdown option is checked. If you uncheck this option, Excel
still forces users to enter only list values (A1:A4), but it won't present a drop-down list.
7. Click OK.

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UNIT-2

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2.1 FINANCIAL MODELING
A financial model is simply a tool that’s built in Excel to forecast a business’ financial
performance into the future. It forecast the financials of the company, keeping in view its short
term and long-term requirements of finance keeping in view the strategic decisions of the
management. Financial modeling is the process by which a firm constructs a financial
representation of some, or all, aspects of the firm or given security. The model is usually
characterize by performing calculations and makes recommendations based on that information.
The model may also summarize particular events for the end user such as investment
management returns or it may help estimate market direction, such as the Fed model.
A financial model can be prepared for various purposes, which are:
 To ascertain the finance required in the company
 To ascertain the working capital requirement of the company, now and in future
 For taking strategic decisions
 To analyze the performance of the company
 To provide a future direction to the performance of the company
 To ascertain the value of the business of the company

2.1.1 STEPS IN BUILDING A FINANCIAL MODEL

The following steps should be followed to build a financial model:

 Building the template

 Filling in the historical data

 Identifying assumptions and drivers

 Forecasting various schedules and financial statement

 Building the supporting schedules

 Various approaches to valuation, key ratios, financial ratios and company analysis

27
  Building cases and sensitivity analysis - looking at the probabilistic analysis of the best
and worst case scenario.

2.1.2 ADVANCED EXCEL TOOLS

1) PV- One of the financial functions, calculates the present value of a loan or an investment,
based on a constant interest rate. You can use PV with either periodic, constant payments (such
as a mortgage or other loan), or a future value that's your investment goal.
Use the Excel Formula Coach to find the present valu (loan amount) you can afford, based on a
set monthly payment. At the same time, you'll learn how to use the PV function in a formula. Or,
use the Excel Formula Coach to find the present value of your financial investment goal.
Syntax-
PV(rate, nper, pmt, [fv], [type])
The PV function syntax has the following arguments:
 Rate Required. The interest rate per period. For example, if you obtain an automobile
loan at a 10 percent annual interest rate and make monthly payments, your interest rate
per month is 10%/12, or 0.83%. You would enter 10%/12, or 0.83%, or 0.0083, into the
formula as the rate.
 Nper Required. The total number of payment periods in an annuity. For example, if
you get a four-year car loan and make monthly payments, your loan has 4*12 (or 48)
periods. You would enter 48 into the formula for nper.
 Pmt Required. The payment made each period and cannot change over the life of the
annuity. Typically, pmt includes principal and interest but no other fees or taxes. For
example, the monthly payments on a $10,000, four-year car loan at 12 percent are
$263.33. You would enter -263.33 into the formula as the pmt. If pmt is omitted, you
must include the fv argument.
 Fv Optional. The future value, or a cash balance you want to attain after the last
payment is made. If fv is omitted, it is assumed to be 0 (the future value of a loan, for
example, is 0). For example, if you want to save $50,000 to pay for a special project in 18

28
 years, then $50,000 is the future value. You could then make a conservative guess at an
interest rate and determine how much you must save each month. If fv is omitted, you
must include the pmt argument.
2) FV- The FV Function Excel formula is categorized under Financial functions. The function
helps calculate the future value of an investment.
As a financial analyst, the FV function helps calculate the future value of investments made by a
business assuming periodic, constant payments with a constant interest rate. It is useful in
evaluating low-risk investments such as certificates of deposit or fixed rate annuities with low
interest rates.
 FV Excel Formula =FV(rate,nper,pmt,[pv],[type])
This function uses the following arguments:
1. Rate (required argument) – It is the interest rate for each period.
2. Nper (required argument) – It is the total number of payment periods in an annuity.
3. Pmt (optional argument) – It specifies the payment per period. If we omit this argument,
we need to provide the PV argument.
4. PV (optional argument) – It specifies the present value (PV) of the annuity. The PV
argument if omitted defaults to zero. If we omit the argument, we need to provide Pmt
argument
5. Type (optional argument) – It defines if payment is made at start or end of the year. The
argument can either ne 0 (payment is made at the end of the period) or 1 (the payment is
made at the start of the period).
3) NPER- The Microsoft Excel NPER function returns the number of periods for an investment
based on an interest rate and a constant payment schedule.
The NPER function is a built-in function in Excel that is categorized as a Financial Function. It
can be used as a worksheet function (WS) and a VBA function (VBA) in Excel. As a worksheet
function, the NPER function can be entered as part of a formula in a cell of a worksheet. As a
VBA function, you can use this function in macro code that is entered through the Microsoft
Visual Basic Editor.
Syntax
The syntax for the NPER function in Microsoft Excel is:
NPER( interest_rate, payment, PV, [FV], [Type] )

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4) PMT- The PMT function calculates a monthly payment amount due on a personal loan.
Syntax = PMT(rate, nper, pv, [fv], [type])
 Rate: It is the interest rate for the loan.
 Nper: It is the total number of payments for the loan.
 Pv: It is the present value; also known as the principal.
 Fv: It is the future value, or the balance that you want to have left after the last payment.
If fv is omitted, the fv is assumed to be zero.
 Type : When payments are due. 0 = end of period. 1 = beginning of period. Default is 0.
5) PPMT- The Microsoft Excel PPMT function returns the payment on the principal for a
particular payment based on an interest rate and a constant payment schedule.
The PPMT function is a built-in function in Excel that is categorized as a Financial Function. It
can be used as a worksheet function (WS) and a VBA function (VBA) in Excel. As a worksheet
function, the PPMT function can be entered as part of a formula in a cell of a worksheet. As a
VBA function, you can use this function in macro code that is entered through the Microsoft
Visual Basic Editor.
Syntax
The syntax for the PPMT function in Microsoft Excel is:
PPMT( interest_rate, period, number_payments, PV, [FV], [Type] )
6) IPMT- Returns the interest payment for a given period for an investment based on periodic,
constant payments and a constant interest rate.
Syntax = IPMT(rate, per, nper, pv, [fv], [type])
 Rate: The interest rate per period.
 Per: The period for which you want to find the interest and must be in the range 1 to nper.
 Nper: The total number of payment periods in an annuity.
 Pv: The present value, or the lump-sum amount that a series of future payments is worth
right now.
 Fv: The future value or a cash balance you want to attain after the last payment is made.
If fv is omitted, it is assumed to be 0 (the future value of a loan, for example, is 0).
 Type - When payments are due. 0 = end of period, 1 = beginning of period. Default is 0.

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7) ACCRINT- It calculates the accrued interest for a security that pays interest on a periodic
basis.
Syntax : ACCRINT( issue_date, first_interest_date, settlement_date, rate, par, frequency, [basis],
[calculation_method] ).
 Issue_date: The date that the security was issued.
 First_interest_date: The date that the first interest will be paid.
 Settlement_date : The settlement date of the security.
 Rate: The annual coupon rate for the security.
 Par: The par value of the security. If this parameter is omitted, the ACCRINT function
will assume that the par is set to $1,000.
 Frequency: The frequency of the interest payments for the security. It can be any of the
following values:
 Annual payments = 1, Semi- annual payments = 2, Quaterly = 4
 Basis: It is the type of day count to use when calculating interest for the security. If this
parameter is omitted, it assumes that the basis is set to 0. It can be any of the following
values: 0 = US (NASD) 30/360, 1 = Actual/Actual, 2 = Actual/360, 3 = Actual/365, 4 =
European 30/360
 calculation_method : It is either of the following values:0 = Calculates the accrued
interest from first_interest_date to settlement_date, 1 = Calculates the accrued interest
from issue_date to settlement_date
8) ACCRINTM- The Microsoft Excel ACCRINTM function returns the accrued interest for a
security that pays interest at maturity.
The ACCRINTM function is a built-in function in Excel that is categorized as a Financial
Function. It can be used as a worksheet function (WS) in Excel. As a worksheet function, the
ACCRINTM function can be entered as part of a formula in a cell of a worksheet.
Syntax
The syntax for the ACCRINTM function in Microsoft Excel is:
ACCRINTM( issue_date, maturity_date, rate, par, [basis] )
9) NPV- The NPV formula is a way of calculating the Net Present Value (NPV) of a series of
cash flows based on a specified discount rate. The NPV formula can be very useful for financial

31
analysis and financial modeling when determining the value of an investment (a company, a
project, a cost-saving initiative, etc.).
NPV for a Series of Cash Flows-
In most cases, a financial analyst needs to calculate the net present value of a series of cash
flows, not just one individual cash flow. The formula works in the same way, however, each
cash flow has to be discounted individually, and then all of them are added together.
10) IRR- It calculates the internal rate of return for a series of cash flows. The cash flows must
occur at regular intervals, but do not have to be the same amounts for each interval.
Syntax = IRR( range, [estimated_irr] )
 Range: A range of cells that represent the series of cash flows.
 Estimated_irr: It is a guess of the internal rate of return. If this parameter is omitted, it
assumes an estimated_irr of 0.1 or 10%.
11) MIRR- Returns the modified internal rate of return for a series of periodic cash flows. MIRR
considers both the cost of the investment and the interest received on reinvestment of cash.
Syntax = MIRR(values, finance_rate, reinvest_rate)
 Values: An array or a reference to cells that contain numbers. These numbers represent a
series of payments (negative values) and income (positive values) occurring at regular
periods. Values must contain at least one positive value and one negative value to
calculate the modified internal rate of return. Otherwise, MIRR returns the #DIV/0! error
value. If an array or reference argument contains text, logical values, or empty cells,
those values are ignored; however, cells with the value zero are included.
 Finance_rate: The interest rate you pay on the money used in the cash flows.
 Reinvest_rate: The interest rate you receive on the cash flows as you reinvest them.
12) MACROS- If you have tasks in Microsoft Excel that you do repeatedly, you can record a
macro to automate those tasks. A macro is an action or a set of actions that you can run as many
times as you want. When you create a macro, you are recording your mouse clicks and
keystrokes. After you create a macro, you can edit it to make minor changes to the way it works.
Suppose that every month, you create a report for your accounting manager. You want to format
the names of the customers with overdue accounts in red, and also apply bold formatting. You
can create and then run a macro that quickly applies these formatting changes to the cells you
select.

32
13) SOLVER- Solver is a Microsoft Excel add-in program you can use for what-if analysis. Use
Solver to find an optimal (maximum or minimum) value for a formula in one cell — called the
objective cell — subject to constraints, or limits, on the values of other formula cells on a
worksheet. Solver works with a group of cells, called decision variables or simply variable cells
that are used in computing the formulas in the objective and constraint cells. Solver adjusts the
values in the decision variable cells to satisfy the limits on constraint cells and produce the result
you want for the objective cell.
Put simply, you can use Solver to determine the maximum or minimum value of one cell by
changing other cells. For example, you can change the amount of your projected advertising
budget and see the effect on your projected profit amount.

2.1.3 COMPONENTS OF FINANCIAL MODELING

Financial statements are a collection of reports about an organization's financial results, financial
condition, and cash flows. They are useful for the following reasons:

 To determine the ability of a business to generate cash, and the sources and uses of that
cash.
 To determine whether a business has the capability to pay back its debts.
 To track financial results on a trend line to spot any looming profitability issues.
 To derive financial ratios from the statements that can indicate the condition of the
business.
 To investigate the details of certain business transactions, as outlined in the disclosures
that accompany the statements.

The financial statement consists of Profit and loss account, balance sheet, and cash flow
statement.
1) Profit & Loss account: A profit and loss account shows a company’s revenue and expenses
over a particular period, typically either one month or consolidated months over a year. Profit
and loss accounts show total income and expenses, and shows whether a business has earned
more income than it has spent on its running costs. If that is the case, then a business has made a
profit. It represents the profitability of a business. The profit and loss account is also known as a

33
P&L report, an income statement, a statement of operation, a statement of financial results, or an
income and expense statement. Profit & Loss account includes

 Income: It comprises of Revenue from main line of business and other income. Gross
revenue is the sales income from main line of business of the company without deducting
any taxes and duties. Taxes and duties are payable to the government under various
statues. For services, it is service tax, for manufacturing activities; it is the excise duty
etc. Gross revenue less the duties/ taxes is called net revenue. Other income is generated
out of some miscellaneous sales, interest received etc. This income is not from the main
line of business of the company.
 Expenses :
 Cost of material consumed: It is the cost of material that is used for production. This
includes, raw material, which includes purchases of raw materials the formula for cost
of material consumed is Opening Stock + Purchases – Closing stock.
 Purchase of Traded Goods : Sometimes, the company uses the traded goods in its
manufacture. This denotes the purchase of goods that are traded.
 Changes in stock ( finished goods and stock in trade): Changes in stock is taken as
opening less closing. The logic behind this is that closing stock is out of current
production (for WIP) and opening stock is used in the current sales of finished goods.
Hence, the difference is used in the profit and loss account as it can be an
expense/income of the company.
 Employee Benefits: Employee benefits relate to the salaries, the compulsory
contributions that the company is expected to pay the employees according to various
statues. The compulsory contributions are the provident fund, Employee state
insurance, leave salary, gratuity etc.
 Finance Costs: Finance costs are the interest costs that the company pays towards
servicing its debts. The debt can be a long-term debt or a term loan. Long term debt is
usually for a long term purpose, for example, any assets that needs to be purchased, or
for any construction of a building etc. the short term debt is usually for working capital
needs and the interest rates for each of these will vary.

34
  Other expenses: the other expenses consists of expenses like advertising, marketing,
printing and stationery, rent, travel, postage, communication expenses, auditing fees,
legal and professional charges etc.
 Depreciation and Amortization: Depreciation is the write off the asset over the useful
life of the asset. Depreciation is used either using straight-line method or written down
value method. The percentages used for the depreciation will be either as per the
companies act or as per the income tax act.

FORMAT OF PROFIT & LOSS ACCOUNT

Profit and Loss account Current Year Previous Year

Gross revenue from operations
Less: Excise duty
Net revenue from operations

Other income
TOTAL REVENUE
Expenses
Cost of material consumed
Purchases of stock in trade

Changes in inventories of finished goods,

Work-in-progress and stock in trade
Employee benefit expenses
Finance costs
Depreciation and Amortisation
Other Expenses
TOTAL EXPENSES
Profit / (Loss) before tax

Tax expense:
Current tax expense for current year

35
 Current tax expense relating to prior years
Net current tax expense
Deferred tax
Profit / (Loss) after tax

2) Balance sheet. A balance sheet (also called the statement of financial position), can be
defined as a statement of a firm’s assets, liabilities and net worth. It provides a snapshot of a
business at a point in time. These are prepared at the end of an accounting period like a month,
quarter or year end. Comparison of balance sheets over years helps to gauge the financial health
of a business. Every business will generally need a balance sheet while applying for loans or
grants, submitting taxes or seeking potential investors. If a business plan to issue financial
statements to outside users (such as investors or lenders), the financial statements should be
formatted in accordance with one of the major accounting frameworks. These frameworks allow
for some leeway in how financial statements can be structured, so statements issued by different
firms even in the same industry are likely to have somewhat different appearances. Financial
statements that are being issued to outside parties may be audited to verify their accuracy. If
financial statements are issued strictly for internal use, there are no guidelines, other than
common usage, for how the statements are to be presented.

Balance sheet is based on the formula: Assets = liabilities + Net worth

Components of the Balance Sheet

The three major components of the balance-sheet that indicate what the company owns and owes
are Assets, Liabilities and Owner’s Equity.
1) Assets: Assets can be defined as the valuables that the company owns to benefit from or are
used to generate income. They are the resources of the company that have future economic
value. These are categorized into tangible and intangible assets. The tangible assets are further
bifurcated into current, long term and other assets. The non tangible assets are trademark,
copyrights, goodwill to mention a few.
•Current assets include the cash, accounts receivable, prepaid expenses and all that can be
converted into cash within a year.

36
•Long term assets are also called fixed assets. They are distinguished from the current assets due
to their longevity in generating revenues. All fixed assets except for land are shown on the
balance-sheet at original cost less depreciation.
2) Liabilities: Liabilities are debts owed by the business. These are claims of the creditors
against the assets of the business. These are claims or obligations that arise out of past or current
transactions. Liabilities are classified into current and long term liabilities.
•Current liabilities are accounts payable, accrued expenses, taxes payable, the current due within
one year portion of long term debt and any other obligations due within a year.
•Long term liabilities are debts that must be repaid by the business in more than one year from
the date of the balance sheet.
•Net worth (Owner’s Equity): Owner’s equity (called when it’s sole proprietorship) sometimes
is also referred to as the book value of the company because owner’s equity is equal to the
reported asset minus the reported liability. It includes:
o Share Capital: It is the amount of money that the shareholders of the company invest in
the company. There are three main types of share capital:
 Authorized share capital: This is the capital the company can raise. At any point of time,
the amount raised as share capital cannot exceed the authorized capital.
 Issued share capital : It is the amount that the company has issued as share capital. Many
times, the company does not issue the entire authorized capital. Only some portion of the
authorized capital is issued.
 Subscribed Capital: It refers to the monetary value of all the shares for which investors
have expressed an interest.

o Reserve and surplus: Reserves are the funds earmarked for a specific purpose, which the
company intends to use in future. Surplus is where the profits of the company reside. This
is one of the points where the balance sheet and the P&L interact.

37
 FORMAT OF BALANCE SHEET

  Beginning Projected

 
Assets  
Current Assets $ $ -
Cash in bank -
Accounts receivable - -
Inventory - -
Prepaid expenses - -
Other current assets - -
Total Current Assets $ -
Fixed Assets
$
Machinery & equipment - $ -
Furniture & fixtures - -
Leasehold improvements - -
Land & buildings - -
Other fixed assets - -
(LESS accumulated depreciation on all                                                                     -  
fixed
Total Fixed Assets (net of depreciation)   $                                                                 - 
Other Assets $ $ -
Intangibles -
Deposits - -
Goodwill - -
Other                                                                     -  
Total Other Assets   $                                                                 - 
TOTAL Assets $ -
Liabilities and Equity  
Current Liabilities $ $ -
Accounts payable -
Interest payable - -
Taxes payable - -
Notes, short-term (due within 12 months) - -
Current part, long-term debt - -
Other current liabilities - -
Total Current Liabilities $ -
Long-term Debt
$
Bank loans payable - $ -
Notes payable to stockholders - -
LESS: Short-term portion - -
Other long term debt - -
Total Long-term Debt $ -
   
Total Liabilities $ -
Owners' Equity
$
Invested capital - $ -
Retained earnings - beginning - -

38
 Retained earnings - current - -
Total Owners' Equity $ -
     
Total Liabilities & Equity $ $ -
-

3) Cash Flow Statement: A Cash Flow Statement (also called the Statement of Cash Flows)
shows how much cash is generated and used during a given time period. It is one of the main
financial statements analysts use in building a three statement model. The main categories found
in a cash flow statement are the:

 Operating activities: Cash flow from operating activities (CFO) is an accounting item
that indicates the amount of money a company brings in from ongoing, regular business
activities, such as manufacturing and selling goods or providing a service. Cash flow
from operating activities does not include long-term capital or investment costs.CFO can
be calculated as follows:

Cash Flow From Operating Activities = EBIT + Depreciation - Taxes +/- Change in
Working Capital

 Investing activities: Cash flow from investing activities is an important aspect of growth
and capital. Changes to property, plant and equipment (PPE), a large line item on the
balance sheet, fall here. When analysts want to know how much a company is spending
on PPE, they can look for the sources and uses of funds in the investing section of the
cash flow statement. Capital expenditures (capex), also found in this section of the cash
flow statement, is a popular measure of capital investment used in the valuation of stocks.
An increase in capital expenditures means the company is investing in future operations,
however, it also points to a reduction in cash flow.

 Financing activities: Cash flow from financing activities measures the movement of
cash between a firm and its owners and creditors. It indicates the means by which a
company raises cash to maintain or grow its operations. A company's source of capital
can be from either debt or equity. When a company takes on debt, it typically does so by
either issuing bonds or taking a loan from the bank. Either way, it must make interest
payments to its bondholders and creditors to compensate them for loaning their money.
When a company goes through the equity route, it issues stock to investors who purchase
the stock for a share in the company. Some companies make dividend payments to
shareholders which represents a cost of equity for the firm. Debt and equity financing are
reflected in the cash flow from financing section which varies with the different capital
structures, dividend policies, or debt terms that companies may have.

39
The total cash provided from or used by each of the three activities will be summed to arrive at
the total change in cash for the period, and then combined with the opening cash balance to
arrive at the cash flow statement’s bottom line, the closing cash balance.

One of the primary reasons cash inflows and outflows are observed is to compare the cash from
operations to net income to gauge how well a company is running its operations. The cash flow
statement reflects the actual amount of money the company receives from its profits. The reason
for the difference between cash and profit is because the income statement is prepared under the
accrual basis of accounting, where it matches revenues and expenses, even though revenues may
actually not have been collected and expenses may not have been paid.

Cash Flow Statement

For the Year Ending
Cash at Beginning of Year

Operations
Cash receipts from
Customers
Other Operations
Cash paid for
Inventory purchases
General operating and administrative expenses
Wage expenses
Interest
Income taxes
Net Cash Flow from Operations

Investing Activities
Cash receipts from
Sale of property and equipment
Collection of principal on loans
Sale of investment securities
Cash paid for
Purchase of property and equipment
Making loans to other entities
Purchase of investment securities
Net Cash Flow from Investing Activities

Financing Activities
Cash receipts from
Issuance of stock
Borrowing
Cash paid for
Repurchase of stock (treasury stock)

40
 Repayment of loans
Dividends
Net Cash Flow from Financing Activities

Net Increase in Cash

2.2 FILLING HISTORICAL DATA
Professionals use services like CapitalIQ or Factset, which offer Excel plug-ins to pull-in
fundamental data from their databases. However, they are expensive. A simplified and less
expensive solution is FetchXL. A similar service from Edgar Online is called I-Metrix, and
costs about the same as FetchXL. The next option is a premium subscription to Morningstar.
They don't offer an Excel plug-in and have fewer details, but the service is affordable The
another inexpensive solution is find annual report in PDF form and copy the material from
there into Excel. Use Excel's Data Text To Columns facility to break the rows into columns.
The result will need some consolidation and alignment, either manually (using Alt key to
select one column), or using trivial Excel macros. Alternatively, there are PDF-reading
programs that give a good result with tables in financial statements. The best is PDF
Transformer+ Preview.

2.3 BUILDING A TEMPLATE

To use the same layout or data in a workbook, we can save it as a template so you can use
the template to create more workbooks instead of starting from scratch. One can make his
own templates to create a new workbook.

Save a workbook as a template

1. Saving a workbook to a template for the first time, start by setting the default personal
templates location:
a. Click File > Options.
b. Click Save, and then under Save workbooks, enter the path to the personal
templates location in the Default personal templates location box.
This path is typically: C:\Users\[UserName]\Documents\Custom Office Templates.

41
c. Click OK.
Once this option is set, all custom templates you save to the My Templates folder automatically
appear under Personal on the New page (File > New).
2. Open the workbook you want to use as a template.
3. Click File > Export.
4. Under Export, click Change File Type.
5. In the Workbook File Types box, double-click Template.
6. In the File name box, type the name you want to use for the template.
7. Click Save, and then close the template.
Insert picture

2.4 IDENTIFYING ASSUMPTIONS AND DRIVERS

Key driver is the factor that influences the conclusion of an activity. The revenue and cost
drivers have to be identified. Revenue drivers relate to factors that impact the cost of the
company.

1) Revenue Drivers: Revenue drivers changes from industry to industry. For a manufacturing
sector, the revenue drivers are the volume of sales and the sales price per unit. For telecom
sector, the revenue driver is the number of subscribers and the average revenue per unit (ARPU).

2) Cost Drivers: Costs can be classified into various categories, variable costs, fixed costs, and
semi fixed costs. The variable cost fluctuates directly with the sales, and the fixed costs remain
constant irrespective of the level of sales. These are the cost that do not change and pertain to the
rent, administration cost etc. Semi-variable costs have two portion, a fixed portion and a variable

42
portion, where the variable portion fluctuates as the sales changes, and the fixed portion remains
unchanged.

Identifying the key drivers:

 Study the historical data to ascertain what generates the revenue and identify the key
revenue drivers
 For the revenue drivers, find out the growth strategy, whether it is organized or
unorganized.
 Find out the new customers that the company is going to acquire.
 Find out the confirmed orders and orders in the pipeline of the company.
 Study the industry to ascertain how the business works.
 Study what regulations govern the company.
 Find out what changes in tax rates is applicable.
 Find out towards what the industry is moving to (mergers etc.).
 An analysis of the past data will show the cost as a percentage of revenue
 What costs fluctuate with revenue.
 What other costs constitute the total costs.
 What is the capital structure of the company and what costs are associated with it
 Find out the future strategy of the company
 For listed companies, the news and press releases will show what the company
plans to do in future.
 For unlisted companies, the management help needs to be taken.
 Project the key drivers and financials.
 Prepare the sub-schedules.
 Prepare the profit and loss account and balance sheet.

43
 2.5 FORECASTING AND BUILDING VARIOUS SCHEDULES AND
FINANCIAL STATEMENT

Common Financial Modeling Approaches

A) Financial Modeling – Income Statement: Line Item Drivers
a) Financial Modeling –Revenues Projections For most companies revenues are a fundamental
driver of economic performance. A well designed and logical revenue model reflecting
accurately the type and amounts of revenue flows is extremely important. There are as many
ways to design a revenue schedule as there are businesses. Some common types include:

1. Sales Growth: Sales growth assumption in each period defines the change from the
previous period. This is simple and commonly used method, but offers no insights into the
components or dynamics of growth.
2. Inflationary and Volume/ Mix effects: Instead of a simple growth assumption, a price
inflation factor and a volume factor are used. This useful approach allows modeling of fixed and
variable costs in multi product companies and takes into account price vs volume movements.
3. Unit Volume, Change in Volume, Average Price and Change in Price: This method is
appropriate for businesses which have simple product mix; it permits analysis of the impact of
several key variables.
4. Dollar Market Size and Growth: Market Share and Change in Share – Useful for cases
where information is available on market dynamics and where these assumptions are likely to be
fundamental to a decision. For Example: Telecom industry
5. Unit Market Size and Growth: This is more detailed than the preceding case and is useful
when pricing in the market is a key variable. (For a company with a price-discounting strategy,
for example, or a best of breed premium priced niche player) e.g. Luxury car market
6. Volume Capacity, Capacity Utilization and Average Price: These assumptions can be
important for businesses where production capacity is important to the decision. (In the purchase
of additional capacity, for example, or to determine whether expansion would require new
investments.)
7. Product Availability and Pricing
8. Revenue driven by investment in capital, marketing or R&D

44
9. Revenue based on installed base (continuing sales of parts, disposables, service and add-
ons etc). Examples include classic razor-blade businesses and businesses like computers where
sales of service, software and upgrades are important. Modeling the installed base is key (new
additions to the base, attrition in the base, continuing revenues per customer etc).
10. Employee based: For example, revenues of professional services firms or sales-based
firms such as brokers. Modeling should focus on net staffing, revenue per employee (often based
on billable hours). More detailed models will include seniority and other factors affecting
pricing.
11. Store, facility or Square footage based: Retail companies are often modeled based on the
basis of stores (old stores plus new stores in each year) and revenue per store.
12. Occupancy-factor based: This approach is applicable to airlines, hotels, movie theatres
and other businesses with low marginal costs.

b) Financial Modeling – Costs projections Drivers include:

1. Percentage of Revenues: Simple but offers no insight into any leverage (economy of

scale or fixed cost burden
2. Costs other than depreciation as a percent of revenues and depreciation from a separate
schedule: This approach is really the minimum acceptable in most cases, and permits only partial
analysis of operating leverage.
3. Variable costs based on revenue or volume, fixed costs based on historical trends and
depreciation from a separate schedule: This approach is the minimum necessary for sensitivity
analysis of profitability based on multiple revenue scenarios

c) Financial Modeling – Operating expenses

1. General and Administrative: Generally treated as % of Revenues

2. Sales and Marketing: Generally modeled as % of Revenues. In some cases, it is actually a
revenue driver and not driven by revenues. For example, brokerage business or pure plays
trading and marketing firms.
3. R&D: Generally R&D costs are treated as % of revenues.

d) Financial Modeling – Interest expense (or Net interest expense):

1. This is one of the few income statement items that is driven by balance sheet information.
A interest schedule is generally developed to i) calculate interest received on cash and short term
investments and ii) calculate interest expenses arising from all types of debt. Interest rate
assumptions are needed.
2. Ending balance of previous year can be used to calculate interest expenses to avoid
circular reference in excel

45
3. Average balance can be used as well (it will give circular reference though)

e) Financial Modeling – Income taxes:

1. Effective tax rate is generally used. Effective rate is calculated as Taxes paid / Pre-Tax
income.
2. For future years, either the marginal tax rate equivalent to the country of incorporation is
taken or if the effective rate is much lesser than the marginal tax rate then during the initial years,
tax rate can be low but gradually would have to be moved to marginal tax rate. For example, In
India, marginal corporate tax rate is 33%.

B) Balance Sheet: Line Item Drivers (Assets)

  Cash and Cash Equivalents:
 Linked to cash from Cash Flow Statement
 Accounts Receivable (Part of Working Capital Schedule):
 Generally modeled as Days Sales Outstanding;
 Receivables turnover = Receivables/Sales * 365
 A more detailed approach ma include aging or receivables by business segment if
the collections vary widely by segments
 Receivables = Receivables turnover days/365*Revenues
 Inventories (Part of Working Capital Schedule):
 Inventories are driven by costs (never by sales);
 Inventory turnover = Inventory/COGS * 365; For Historical
 Assume an Inventory turnover number for future years based on historical trend
or management guidance and then compute the Inventory using the formula given below
 Inventory = Inventory turnover days/365*COGS; For Forecast
 Other Current Assets (Part of Working Capital Schedule):
 Modeled as % of sales
 Fixed Assets (Property, Plant and Equipment)
 Separate schedule is prepared taking into account various components
 Ending Balance for PPE = Beginning balance + Capex – Depreciation –
Adjustment for Asset Sales

C) Balance Sheet: Line Item Drivers (Liabilities)

 Financial Modeling – Current Liabilities Projections
 Accounts Payables (Part of Working Capital Schedule):

46
 Payables turnover = Payables/COGS * 365; For Historical
 Assume Payables turnover days for future years based on historical trend or
management guidance and then compute the Accounts Payables using the formula given below
 Accounts Payables = Payables turnover days/365*COGS
 Short Term Debt: Usually modeled as part of debt schedule
 Accrued Liabilities: Kept constant most often; Can be modeled as % of sales
 Deferred taxes: Kept constant most often; Can be modeled as % of sales
 Other Current Liabilities: Can be modeled as % of COGS or as % of Sales
 Long term Liabilities:
 Deferred taxes: Kept constant most often; Can be modeled as % of sales
 Post retirement Pension Cost: Kept constant most often
 Long term Debt: Usually modeled as part of debt schedule (please refer debt
schedule on next page)
 Key feature of the debt schedule is to use the Revolver facility and how it works
so that the minimum cash balance is maintained and ensures that the Cash account does not
become negative in case the operating cash flow is negative  (Companies in investment phase
who need lot of debt in initial years of operation – Telecom cos for example)
 Overall range of Debt to equity ratio should be maintained if there is any guidance
by the management
 Debt balance can also be assumed to be constant unless there is a need to increase
the debt
 Notes to the accounts would give repayment terms and conditions which need to
be accounted for while building the debt schedule
 For some industries, like Airlines, Retail etc Operating Leases might have to
capitalized and converted to debt. However, this is a complex topic and beyond the scope of
discussion at this point

Example: Given below is the detail of company ABC (P) Limited. Please prepare the projected
profit and loss account and the balance sheet.

1) Sales of the company comprises of three parts, Sale of product A, sale of product B and the
Service/maintenance of the products (AMC). Sale of product B is dependent on sale of product A
and is one per client. It is assumed that minimum order quantity of product A, will be 25 each
year per client.

47
 Clients targeted each year Y1 Y2 Y3 Y4 Y5
Number of clients 10 50 75 100 200
Existing Customers 5 5 10 13 20
Selling Price of Product A per unit 30,000 35,000 40,000 45,000 45,000
Selling Price of Product B per unit 30,000 30,000 35,000 35,000 35,000

AMC per product A is Rs. 500, and per product, B is Rs. 1000, with 10% increases YoY. AMC
will start from year 2 as for the first year there is a warranty. It is assumed that 60% of the total
customers will opt for AMC.

2) Cost of goods sold is as follows:

Cost of goods sold Y1 Y2 Y3 Y4 Y5
Cost of product A per unit 4,500 4,725 4,961 5,209 5,470
Cost of product B per unit 4,500 4,725 4,961 5,209 5,470

3) The following table shows the manpower requirement and salaries per person.

Manpower Requirement Y1 Y2 Y3 Y4 Y5
CEO 1 1 1 1 1
CFO 1 1 1 1 1
Software Engineer 4 4 2 2 2
Senior Software Engineer - - - - -
Hardware Engineer 3 3 1 1 1
Senior Hardware Engineer 1 1 - - -
Support Engineer 1 4 10 24 46
Sales Executive 2 2 3 5 10
Account Manager 1 2 4 10 20
Marketing Manager - - 1 1 1
HR Manager - - 1 1 1
Workers 10 10 10 10 10
Total 24 28 34 56 93

The salary per annum per category is as follows:

Salaries Y1 Y2 Y3 Y4 Y5
CEO 10,00,000 12,00,000 20,00,000 30,00,000 45,00,000
CFO 10,00,000 12,00,000 20,00,000 30,00,000 45,00,000
Software Engineer 6,60,000 7,26,000 7,98,600 8,78,460 9,66,306
Senior Software Engineer 8,00,000 8,80,000 9,68,000 10,64,800 11,71,280
Hardware Engineer 2,20,000 2,42,000 2,66,200 2,92,820 3,22,102
Senior Hardware 8,00,000 8,80,000 9,68,000 10,64,800 11,71,280

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 Engineer
Support Engineer 1,20,000 1,32,000 1,45,200 1,59,720 1,75,692
Sales Executive 2,40,000 2,64,000 2,90,400 3,19,440 3,51,384
Account Manager 6,00,000 6,60,000 7,26,000 7,98,600 8,78,460
Marketing Manager 6,00,000 6,60,000 7,26,000 7,98,600 8,78,460
HR Manager 6,00,000 6,60,000 7,26,000 7,98,600 8,78,460
Workers 1,50,000 1,65,000 1,81,500 1,99,650 2,19,615

4) Rent per month is Rs. 50,000/-, 10% increase p.a

5) Telephone cost – for support function, 20 calls per client, call rate @ Rs.3/-. Sales call 6000,
15000, 20,000, 30000 and 50,000 for years Y1 to Y5. Personal calls of employees, Rs. 50 per
month per employee.
6) Electricity charges are Rs. 50000 pm, with 10% increase YoY.
7) Training expenses to be provided at Rs. 100000 pa, with 20% YoY increase.
8) Travel costs Rs. 50000 pm, with 10% increase YoY.
9) Printing and stationery cost Rs. 5000 pm, with 5% increase YoY.
10) Books and periodicals Rs 3000 pm, with 10% increase YoY.
11) Membership and subscriptions, Rs.25,000 pm with 15% increase YoY
12) Consultancy charges Rs.20,000 pm, YoY, 5% increase
13) Other miscellaneous expenses Rs.5000 pm, YoY 10% increase.
14) Capital expenditure details are as follows:
Gross block is given below:
Gross Block Depreciation Y1 Y2 Y3 Y4 Y5
Software 60% 500000 600000 1600000 3500000 6500000
Engineering tools 40% 900000 1600000 2400000 3200000 4000000
and components
Hardware Tools 40% 1100000 1200000 1500000 1800000 2000000
Total 2500000 3400000 5500000 8500000 12500000

Depreciation is calculated on the SLM basis

15) The company has a term loan of Rs. 25 lakhs taken at an interest rate of 14%, repayable over
5 Years.

16) The tax rate applicable for the company is 32.45%.

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17) Debtors are 60 days sales, and creditors are 30 days of cost of good sold, expenses payable is
15 days, inventory is 30 days. Capital infused in the business is Rs. 70lakhs

Solution. The projected Profit and Loss account and Balance sheet can be prepared with the help
of following schedules
1) Revenue schedule:

50
 2) Cost of Goods S

3) Salaries

51
4) -13) Expenses

52
14) Depreciation

15) – 17)

53
54
2.6 VARIOUS APPROACHES TO VALUATION

55
American Institute of Chartered Public Accountants (AICPA) prescribes three approaches to
valuation. These approaches are:
1) Income Based approach: This approach values the company based on the future income that
the company can generate. The common method used in the valuation is the discounted cash
flow method and capitalization method.
 Capitalization of benefits method: The valuation of the future cash flows of the company
requires the following adjustments.
 Normalization adjustments- any business operates in a normal condition, and the
activities take place in a normal course. There may be situations that arise, where
the company may function slightly exceptional, for example, there may be on
huge one-time sales order, which the company undertakes, and this may not recur
every year. These kinds of abnormal adjustments need to be made to arrive at the
normal profits of the company.
 Nonrecurring revenue and expense items- any expense and income should be
recurring. Onetime expenses will have only bearing in the cash flow of the
company. Hence, the revenue expenses that occur should be considered.
 Taxes-the relevant tax rate has to be considered and the tax amortization benefit
has to be considered for valuation of intangibles.
 Capital structure and financing costs-capital structure refers to the composition of
the shareholders funds and the external funds. This is relevant for arriving at the
cost of capital.
 Appropriate capital investments – these have to be considered, as they will have
an impact on the cash flow. Especially if the company is using debt to finance its
capital expenditure, the cash flow to the extent of debt does not get affected.
 Non cash items – non cash items do not have any relevance in cash flow hence
needs to be removed.
 Qualitative judgments for risks used to compute discount and capitalization rates-
the usage of cost of capital and discounting rates is generally a very subjective
factor. The method chosen to arrive at the cost of capital and its relevance has to
be best suited for valuation, else the valuation will not show the current picture.

56
  Expected changes in future benefits (e.g. earnings or cash flows).

 Discounted future benefits method : In addition to the items in a above, the valuation
analyst should consider:
 Forecast/projection assumptions – forecast has to have assumptions, that the
valuer obtains from the management and the industry.
 Forecast/projected earnings or cash flows – these are based on the projection
assumptions.
 Terminal value – this is the future values of all the cash flows till perpetuity of the
company based on growing concern concept.

2) Asset based approach: This is also called as the cost approach. A frequently used method
under the approach is the adjusted net asset method. When using the adjusted net asset method in
valuing a business, business ownership interest, or security, the valuation analyst should
consider, as appropriate, the following information related to the premise of value:
 Identification of the assets and liabilities.
 Value of the assets and liabilities
 Liquidation costs.
When using methods under the cost approach to value intangible assets, the valuation analyst
should consider the type of cost to be used (reproduction cost or replacement cost), and where
applicable, the appropriate forms of depreciation and obsolescence and the remaining useful life
of the intangible asset.

3) Market based approach: Three frequently used valuation methods under the market
approach for valuing a business, business ownership interest, or security are:
 Guideline public company method – Under this method, the publicly traded company’s
data is used for comparison, and the multiple based approach is considered.
 Guideline company transactions method: Under this method the published data is taken,
based on some recent transactions that have taken place. The onus reliability of the
published data is on the valuer.

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  Guideline sales of interests in the subject entity, such as business ownership interests or
security.
Three frequently used market approach valuation methods for intangible assets are:
 Comparable uncontrolled transactions method
 Comparable profit margin method
 Relief from royalty method
For the methods involving guideline intangible assets, the valuation analyst should consider the
subject intangible asset’s remaining useful life relative to the remaining useful life of the
guideline intangible assets, if available.
In applying the above methods under market approach, methods to determine valuation pricing
multiples or metrics, the valuation analyst should consider:
 Qualitative and quantitative comparisons
 Arm’s-length transactions and prices
 The dates and, consequently, the relevance of the market data.
The valuation analyst should set forth in the report the rationale and support the valuation
methods used.

2.7 RATIO ANALYSIS

Ratio analysis is the process of determining and interpreting numerical relationships based on
financial statements. A ratio is a statistical yardstick that provides a measure of the relationship
between two variables or figures.
This relationship can be expressed as a percent or as a quotient. Ratios are simple to calculate
and easy to understand. The persons interested in the analysis of financial statements can be
grouped under three heads,
i) Owners or investors
ii) Creditors and
iii) Financial executives.
Although all these three groups are interested in the financial conditions and operating results, of
an enterprise, the primary information that each seeks to obtain from these statements differs
materially, reflecting the purpose that the statement is to serve.

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Investors desire primarily a basis for estimating earning capacity. Creditors are concerned
primarily with liquidity and ability to pay interest and redeem loan within a specified period.
Management is interested in evolving analytical tools that will measure costs, efficiency,
liquidity and profitability with a view to make intelligent decisions.
Classification of Ratios:
Financial ratios can be classified under the following five groups:
1) Structural
2) Liquidity
3) Profitability
4) Turnover
5) Miscellaneous.
1. Structural group:
The following are the ratios in structural group:
i) Funded debt to total capitalization: The term ‘total’ capitalization comprises loan term debt,
capital stock and reserves and surplus. The ratio of funded debt to total capitalisation is
computed by dividing funded debt by total capitalisation.
Debt to total capitalization = (Short term debt + Long term debt) / (Short term debt + Long term
debt + Shareholder’s Equity).
ii) Debt to equity: Due care must be given to the; computation and interpretation of this ratio.
The definition of debt takes two foremost. One includes the current liabilities while the other
excludes them. Hence, the ratio may be calculated as:
Debt Equity Ratio = Total Long Term Debts / Shareholders Fund
iii) Capital gearing ratio: It is a useful tool to analyze the capital structure of a company and is
computed by dividing the common stockholders’ equity by fixed interest or dividend bearing
funds. Analyzing capital structure means measuring the relationship between the funds provided
by common stockholders and the funds provided by those who receive a periodic interest or
dividend at a fixed rate. A company is said to be low geared if the larger portion of the capital is
composed of common stockholders’ equity. On the other hand, the company is said to be highly
geared if the larger portion of the capital is composed of fixed interest/dividend bearing funds.
Capital Gearing ratio = Equity Share Capital / Fixed Interest Bearing Funds

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iv) Debt Service Ratio: The Debt-Service Coverage Ratio (DSCR) is a measure of the cash flow
available to pay current debt obligations. The ratio states net operating income as a multiple of
debt obligations due within one year, including interest, principal, sinking-fund and lease
payments.
Debt Service Ratio = Net profit Before Interest & Taxes / Fixed Interest Charges
2. Liquidity group:
i) Current ratio: It is computed by dividing current assets by current liabilities. This ratio is
generally an acceptable measure of short-term solvency as it indicates the extent to which he
claims of short term creditors are covered by assets that are likely to be converted into cash in a
period corresponding to the maturity of the claims.
Current Ratio = Current assets / Current liabilities
ii) Acid-test ratio: It is also termed as quick ratio. It is determined by dividing “quick assets”,
i.e., cash, marketable investments and sundry debtors, by current liabilities. This ratio is a
bitterest of financial strength than the current ratio as it gives no consideration to inventory
which may be very a low- moving.
Quick Ratio = Liquid Assets/Current Liabilities
3. Profitability Group:
(i) Gross Profit Margin: It compares gross profit to sales revenue. This shows how much a
business is earning, taking into account the needed costs to produce its goods and services. A
high gross profit ratio represents a higher efficiency of core operations, meaning it can still cover
operating expenses, fixed costs, dividends, and depreciation, while also providing net earnings to
the business. On the other hand, a low profit margin encompasses a high cost of goods sold,
which can be attributed to adverse purchasing policies, low selling prices, low sales, stiff market
competition, or wrong sales promotion policies.
Gross Profit Ratio = Gross Profit/Net Sales X 100

(ii) Operating Profit Margin: Operating profit margin looks at earnings as a percentage of sales
before income tax is taken away. Companies with high operating profit margins are generally
more equipped to pay for fixed costs and interest on obligations, have better chances to survive
an economic slowdown, and are more capable of offering lower prices than their competitors
who have a low profit margin.

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Operating Profit ratio Operating Profit/Net Sales X 100

(iii) Cash Flow Margin: Cash flow margin – expresses the relationship between cash flows
from operating activities and sales generated by the business. It measures the ability of the
company to convert sales into cash. The higher the percentage of cash flow means the more cash
available from sales to pay for suppliers, dividends, utilities, and debt as well as purchase capital
assets. Negative cash flow, however, connotes that even if the business is generating sales, it is
still losing money. In this case, the company has an option to borrow funds or raise money
through investors in order to keep the operations going.
Cash Flow Margin = Cash flows from operating activities/net sales
(iv) Return on Assets: It shows the percentage of net earnings relative to the company’s total
assets, in other words, how much a company generates for every one dollar of assets, after-tax
profit. This also measures the asset intensity of a business, meaning the lower the profit per
dollar of assets, the more asset-intensive a company is. In contrast, the higher the profit per
dollar of assets, the less asset-intensive a company is. Highly asset-intensive companies require
big investments to purchase machinery and equipment in order to generate income. Examples
are: telecommunications services, car manufacturers, and railroads. Less asset-intensive
companies are: advertising agencies and software companies.
Return on assets = Net Income/ Total Assets

(v) Return on Equity: It expresses the percentage of net income to stockholder’s equity or the
rate of return on the money the investors put into the business. This is also the ratio that potential
investors are referring to when deciding whether to invest or not. A high return on equity is more
capable of generating cash internally. Usually, return rates ranging from 13% to 15% illustrate a
healthy ROE.
Return on Equity = Net Income/Shareholder's Equity

(vi) Return on Invested Capital: It is a measure of return generated by all providers of capital,
including both bondholders and shareholders
ROIC = EBIT x (1 – tax rate) / (value of debt + value of + equity).

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EBIT is used because it’s before interest expense, and therefore represents earnings that are
available to all investors, not just shareholders.

4. Turnover group:
It has four ratios, and they are calculated as follows:
(i) Accounts receivable turnover ratio. Measures the time it takes to collect an average amount
of accounts receivable. It can be impacted by the corporate credit policy, payment terms, the
accuracy of billings, the activity level of the collections staff, the promptness of deduction
processing, and a multitude of other factors.
Accounts receivable turnover = Net credit sales/ Average Accounts receivable

(ii) Inventory turnover ratio: Measures the amount of inventory that must be maintained to
support a given amount of sales. It can be impacted by the type of production process flow
system used, the presence of obsolete inventory, management's policy for filling orders,
inventory record accuracy, the use of manufacturing outsourcing, and so on.
Inventory turnover = Net Sales / Inventory

(iii) Fixed asset turnover ratio : Measures the fixed asset investment needed to maintain a
given amount of sales. It can be impacted by the use of throughput analysis, manufacturing
outsourcing, capacity management, and other factors.
Fixed Assets Turnover = Cost of goods Sold / Total Fixed Assets

(iv) Accounts payable turnover ratio : Measures the time period over which a company is
allowed to hold trade payables before being obligated to pay suppliers. It is primarily impacted
by the terms negotiated with suppliers and the presence of early payment discounts.
Accounts payable turnover = Total supplier purchases/ average Accounts payable

5. Miscellaneous group:
It contains four ratio and they are as follows:
(i) Earning price ratio = EPS/MP

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(ii) Price – Earning ratio = MP/EPS
(iii) Dividend – yield ratio = DPS/MP
(iv) Pay – out ratio = DPS/EPS
Where,
EPS = Net profit after dividend/No. of outstanding ordinary shares
DPS = Dividends for ordinary shares/ No. of outstanding ordinary shares
MP = Market price per share.

2.7.1 STANDARDS FOR COMPARISON

For making a proper use of ratios, it is essential to have fixed standards for comparison. A ratio
by itself has very little meaning unless it is compared to some appropriate standard. Selection of
proper standards of comparison is a most important element in ratio analysis. The four most
common standards used in ratio analysis are; absolute, historical, horizontal and budgeted.
Absolute standards are those which become generally recognised as being desirable regardless of
the company, the time, the stage of business cycle, or the objectives of the analyst. Historical
standards involve comparing a company’s own’ past performance as a standard for the present or
future.
In Horizontal standards, one company is compared with another or with the average of other
companies of the same nature.
The budgeted standards are arrived at after preparing the budget for a period Ratios developed
from actual performance are compared to the planned ratios in the budget in order to examine the
degree of accomplishment of the anticipated targets of the firm.
Limitations:
The following are the limitations of ratio analysis:
1. It is always a challenging job to find an adequate standard. The conclusions drawn from the
ratios can be no better than the standards against which they are compared.
2. When the two companies are of substantially different size, age and diversified products,,
comparison between them will be more difficult.
3. A change in price level can seriously affect the validity of comparisons of ratios computed for
different time periods and particularly in case of ratios whose numerator and denominator are
expressed in different kinds of rupees.

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4. Comparisons are also made difficult due to differences of the terms like gross profit, operating
profit, net profit etc.
5. If companies resort to ‘window dressing’, outsiders cannot look into the facts and affect the
validity of comparison.
6. Financial statements are based upon part performance and part events which can only be
guides to the extent they can reasonably be considered as dues to the future.
7. Ratios do not provide a definite answer to financial problems. There is always the question of
judgment as to what significance should be given to the figures. Thus, one must rely upon one’s
own good sense in selecting and evaluating the ratios.

2.8 SENSITIVITY ANALYSIS

A sensitivity analysis is a technique used to determine how different values of an independent
variable impact a particular dependent variable under a given set of assumptions. It helps in
decision making and understanding of the model clearly. This analysis shows the changes in one
factor and its impact on the other.

Example:
Sales quantity 1500
Selling Price 100
Variable cost 50/unit
Fixed cost 50000

Calculate the following:

(i) Quantity change from 1000 to 1500, and impact on profit
(ii) Fixed cost changes from -15% to 15%, and impact on profit.
(iii) Variable cost changes from 40 to 60, quantity changes from 1000 to 1500, and its impact on
profit.

1) Quantity changes from 1000 to 1500

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2) Fixed cost changes from -15% to 15%, and impact on profit.

3) Variable cost changes from 40 to 60, quantity changes from 1000 to 1500, and its impact on
profit.

2.9 PROBABILISTIC ANALYSIS OF THE BEST AND WORST CASE SCENARIO.

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With risky assets, the actual cash flows can be very different from expectations.
At the minimum, we can estimate the cash flows if everything works to perfection – a best case
scenario – and if nothing does – a worse case scenario. In practice, this analysis can be structured
in two ways. In the first, each input into asset value is set to its best (or worst) possible outcome
and the cash flows estimated with those values. Thus, when valuing a firm, you may set the
revenue growth rate and operating margin at the highest possible level while setting the discount
rate at its lowest level, and compute the value as the best-case scenario. The problem with this
approach is that it may not be feasible; after all, to get the high revenue growth, the firm may
have to lower prices and accept lower margins. In the second, the best possible scenario is
defined in terms of what is feasible while allowing for the relationship between the inputs. Thus,
instead of assuming that revenue growth and margins will both be maximized, we will choose
that combination of growth and margin that is feasible and yields the maximum value. While
this approach is more realistic, it does require more work to put into practice. There are two ways
in which the results from this analysis can be useful to decision makers. First, the difference
between the best case and worst case values can be used as a measure of risk on an asset; the
range in value (scaled to size) should be higher for riskier investments. Second, firms that are
concerned about the potential spill over effects on their operations of an investment going bad
may be able to gauge the effects by looking at the worst case outcome. Thus, a firm that has
significant debt obligations may use the worst case outcome to make a judgment as to whether an
investment has the potential to push them into default.
The Steps involved in analyzing the probabilistic analysis are as follows:
1. Identify the factors based on which the model will be built.
2. Ascertain the number of situations that needs to be analysed.
3. Arrive at the cash flows from each situation.
4. Assign probabilities to each of the scenarios.
For example: in the shipping industry, say a company has manufactures ships and income is from
selling these ships to the customers. This company is planning to introduce another ship based on
the seating capacity. Currently, say the ship offers only 1000 seats, the company due to demand
is planning to offer a ship that can hold 1500 passengers. The uncertainties are the demand, the
customer preferences, growth in the market, acceptance of the design from the prospective

66
buyers etc. we can consider three scenarios for the demand/sales factor, i.e, growth rate,
moderate growth rate and low growth rate. High growth rate say 10%, moderate growth rate 5%-
10%. So in these situations, the sales numbers projected will differ as shown below:
10% growth rate 5%-10% growth rate Below 5% rate
Sales 150 100 50

Hence the projections, the cash flows and the valuation will vary in each situation. The difficulty
is in ascertaining the numbers of sales and assigning the probabilities. This can be done by
persons who have a strong understanding of the industry.
The management can assign the probability, based on the likely hood of the event, say the worst
(lowest demand, i.e below 5%) situation is given a probability of 0.15, ie there are only 15%
chances of salesfalling below 5% rate, and most likely 5%-10% is 0.6, i.e., 60% and optimistic
situation is say 0.25, i.e 25%. These probabilities have to be assigned carefully as they will have
an impact on decision-making.

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68
 UNIT-3

3.1 STRUCTURED MODEL WITH A MENU & ACCOUNTING STATEMENTS

A structured model links the income statement, balance sheet, and cash flow statement into one
dynamically connected model.  Accounting statement models are the foundation on which more
advanced financial models are built such as discounted cash flow DCF models, mergers models,
leveraged buyout LBO models, and various other types of financial models.

There are several steps required to build an accounting statement model, including:

 Input the historical financial information into Excel

 Determine the assumptions that will drive the forecast
 Forecast the income statement
 Forecast capital assets
 Forecast financing activity
 Forecast the balance sheet
 Complete the cash flow statement

A structured model with a menu and accounting statements can be shown as:

1) Table of Contents

69
2) Revenue, cost and expense projections

70
71
3) Income statement

72
4) Balance Sheet statement

4) Cash Flow statement

73
3.2 KEY FINANCIAL RATIOS

Example: Given below is the income statement and balance sheet of the company, Calculate the
current ratio, quick ratio, gross profit ratio, net operating profit ratio & inventory turnover ratio.

Income statement for the year ended 31.03.2012

Particulars Amount in Rs.

Gross Sales 5500000
Less: Excise Duty 440000
Net Sales 5060000
Raw material 2000000
Direct Labour 1000000
Direct Expenses 500000 3500000
Gross profit 1560000
Other expenses 60000
Depreciation 350000
Operating Profit 1150000
Interest 150000
Profit Before Tax 1000000
Taxation 324500
PAT 675500

Balance sheet

Liabilities 31.03.2012 31.03.2011

Share Capital 3000000 3000000

Retained earnings 1675500 1000000
Net worth 4675500 4000000

Long term loan 2024500 2000000

Current Liabilities
Creditors 200000 250000
Expense outstanding 50000 75000
Current Liabilities 250000 325000

Total Liabilities 6950000 6325000

Assets
Fixed assets 3500000 3000000
Less: Depreciation 1850000 1500000
Net block 1650000 1500000

Investments 1000000 1000000

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 Inventories 1500000 1200000
Debtors 500000 300000
Loans and advances 2000000 2000000
Cash and bank 300000 325000
Total current assets 4300000 3825000

Total assets 6950000 6325000

3.3 TIME VALUE OF MONEY

When money is invested today, after a year, it will give us a rate of return. This return enhances
the value of money. Hence, what value of money is today, will not be the same after a period of
time. For example, if A invests Rs.1000 today at 8% interest per annum, the amount he will get
is Rs.1080/-. Whether A gets Rs.1000 today, or Rs.1080 after a year, the value is the same. This
is called time value of money. These values of the business have to be ascertained based on the
money that the business generates. The value of money generated by the business tomorrow is
not equal to what it is today. The interest rate/investment rate has to be ascertained in every
business. This rate is what is called the discount rate.

Cost of Capital

Ascertaining the discount rate is crucial to valuation and it plays a vital role in valuation. To
ascertain the discounting factor, either cost of capital can be used or weighted average cost of
capital can be used for arriving at the rate at which the present value of future cash flow can be
ascertained.

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The most commonly used model is the capital asset pricing model (CAPM) which arrives at the
rate of return of an asset. The formula for cost of equity is

Cost of equity = Risk free rate + Beta*market premium

Where, the market premium is the difference between the market rate of return for a security less
the risk free rate.

After arriving at the discounting factor, the same is used for finding out the present value of
future cash flows.

Example:

Particulars Rs. Cost

Equity Capital 200000 15%
Preference Capital 500000 12%
Debentures 3000000 6%

Weights of equity, preference, and debentures are 36%, 9%, and 55% respectively. Calculate
cost of capital

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3.4 CAPITAL BUDGETING MODEL

Capital budgeting, or investment appraisal, is the planning process used to determine whether an
organization's long term investments such as new machinery, replacement machinery, new
plants, new products, and research development projects are worth the funding of cash through
the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating
resources for major capital, or investment, expenditures. One of the primary goals of capital
budgeting investments is to increase the value of the firm to the shareholders.

Techniques based on accounting earnings and accounting rules are sometimes used - though
economists consider this to be improper - such as the accounting rate of return, and "return on
investment." Simplified and hybrid methods are used as well, such as payback period and
discounted payback period.

 Net present value

Capital budgeting projects are classified as either Independent Projects or Mutually Exclusive
Projects. An Independent Project is a project whose cash flows are not affected by the
accept/reject decision for other projects. Thus, all Independent Projects which meet the Capital
Budgeting criterion should be accepted.

Mutually exclusive projects are a set of projects from which at most one will be accepted. For
example, a set of projects which are to accomplish the same task. Thus, when choosing between
"mutually exclusive projects", more than one project may satisfy the capital budgeting criterion.
However, only one, i.e., the best, project can be accepted.

Of these three, only the net present value and internal rate of return decision rules consider all of
the project's cash flows and the time value of money. As we shall see, only the net present value
decision rule will always lead to the correct decision when choosing among mutually exclusive
projects. This is because the net present value and internal rate of return decision rules differ
with respect to their reinvestment rate assumptions. The net present value decision rule implicitly
assumes that the project's cash flows can be reinvested at the firm's cost of capital, whereas the
internal rate of return decision rule implicitly assumes that the cash flows can be reinvested at the
project's IRR. Since each project is likely to have a different IRR, the assumption underlying the
net present value decision rule is more reasonable.

Example : Business makes an investment of $10,000; and will receive an annual income of
$3,000, $4,200, and w$6,800 in the three years that follow; an annual discount rate of 10%.
Calculate NPV and XNPV.

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  Internal rate of return

The internal rate of return (IRR) is defined as the discount rate that gives a net present value
(NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually
exclusive) projects in an unconstrained environment, in the usual cases where a negative cash
flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases,
all independent projects that have an IRR higher than the hurdle rate should be accepted.
Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the
highest IRR - which is often used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR
exists and is unique if one or more years of net investment (negative cash flow) are followed by
years of net revenues. But if the signs of the cash flows change more than once, there may be
several IRRs. The IRR equation generally cannot be solved analytically but only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual
annual profitability of an investment. However, this is not the case because intermediate cash
flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is
almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of
Return (MIRR) is often used.

Example : Business makes an investment of $10,000; and will receive an annual income of
$3,000, $4,200, and w$6,800 in the three years that follow; an annual discount rate of 10%.
Reinvestment rate is 7%. Calculate IRR and MIRR.

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3.4.1 NEED FOR CAPITAL BUDGETING

1. As large sum of money is involved which influences the profitability of the firm, making
capital budgeting an important task.

2. Long term investment once made cannot be reversed without significance loss of invested
capital. The investment becomes sunk, and mistakes, rather than being readily rectified, must
often be borne until the firm can be withdrawn through depreciation charges or liquidation. It
influences the whole conduct of the business for the years to come.

3. Investment decision are the base on which the profit will be earned and probably measured
through the return on the capital. A proper mix of capital investment is quite important to ensure
adequate rate of return on investment, calling for the need of capital budgeting.

4. The implication of long term investment decisions are more extensive than those of short run
decisions because of time factor involved, capital budgeting decisions are subject to the higher
degree of risk and uncertainty than short run decision.

3.4.2 DIVIDEND DISCOUNT MODELS

Dividend discount model, is a method by which the dividends are discounted to arrive at the
value of one share. It was conceptualized by Myron J Gordon, and also called as Gorden growth
model. The formula is as follows:

Current stock price = Dividend/(Cost of equity- growth rate)

Though this model emphasizes on the finding out the current stock price, in valuation, it is used
to find out the terminal value of the company. The projection of the final year, is taken as
numerator and divided by the difference of the cost of equity and growth rate to arrive at the
terminal value.

The idea behind this is model is that the company is constantly growing at a perpetual rate. This
rate is reduced from the return, as the growth will ensure that the investors will reap their returns.
Hence, this method is commonly used to find the perpetuity value. The growth rate cannot be
higher than the cost of equity.

Examples:
ABC company’s current market price of share is Rs.10/-. The company pays a dividend of
Rs.0.50 per share. The growth rate of the company is expected to be 3% per annum. Compute the
Cost of equity capital.

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3.5 MARKET BASED METHODS

When an investor invests, the first thing that he does, is that he enquires if there has been similar
transactions that have happened in the same industry to see at what was it acquired. Valuation is
not only numbers, but can also denoted as 2X, or 5X of some variable. This variable can be the
revenue, EBITDA or the PAT. These have a bearing in the valuation.
The steps involved in the market based approach is as follows:
 Ascertain the peer group. The companies in the same industry, that are into the same kind
of business, is called the peer group.
 The peer group companies must be comparable in size and nature to the company that is
being valued.
 The peer group companies must be listed in the market, i.e., the stocks of which trade in
the listed stock exchange.
 Once, the peer group is identified, the valuation can be either revenue based or EBITDA
based, or PAT based.

Revenue of each companies is taken and the revenue multiple is ascertained. The revenue
multiple is calculated using the following formula:

Aggregate EV of all the companies / aggregate revenue of all the companies

EV is enterprise value. The enterprise value is defined as the market capitalization less the debt
and cash is added. Market capitalization shows the market value of the firm and it computed by
multiplying the number of shares and the current quoted market price. The quoted market price
has to be taken as on the valuation date. The enterprise value is the market capital + debt – cash.
Debt is added as any investor, who is going to acquire the company or invest in the company has
to repay the debt and the cash is substracted as any investor who takes over has that amount of
cash to repay the debt. In case the company has preference capital and minority interest, then the
formula is as follows:

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Market capitalization + Preference capital + minority interest + debt – cash and cash equivalents.

Preference capital, minority interest, associate company value, debt, all have to be taken at
market value. Basically, enterprise value depicts the market value of the firm. Preference capital
is added as market capitalisation only considers the outstanding equity shares. Minority interest
is that part that is not held by the holding company, but it is the claim of the minority share
holders, and has an impact during consolidation.

Significance of EV/ EBITDA

Enterprise values the businesses based on their market capitalisation. For listed companies, the
market capitalisation is the total shares multiplied by the share price as on a given date.
However, EV is not deal only with the market. The stock prices always don not reflect the true
value of the company. Sometimes, a good asset backed stock may also fall below its book value,
due to external factors like government regulations, global recession etc.
EV/EBITDA gives the operating profit multiple as a times of the enterprise value. It is an
important tool to compare different companies of different counteries as it ingnores the taxation
effect. Also, this helps in comparisons of comopanies, which have a different capital structure.
EV is better than Market capitalisation as it assumes the debt. Hence, this multiple considers the
liability that the company has to assume in case of acquisition or merger. Lower the EV, better is
the position for the acquirer.

Significance of EV/Sales

This ratio signifies the value of the company in terms of its sales. This multiple, shows how
many times the sales is the EV. This is beneficial as the acquirer/purchaser will know how much
it costs to buy the sales of the company. This is better than the price to sales valuation as the
price to sales value takes the market price, whereas this takes into account the debt and takes a
more realistic picture.

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