Financial Modelling and Valuation

Objectives

• Understand how companies make money

• How can investors evaluate these decisions to create long term wealth

• Evaluate Strategic Decisions – Financially

 Methods to Evaluate Projects

• Net Present Value

• Internal Rate of Return

• Payback Period
 Pre - requisites

• Time Value of Money

• Inflation

• Compounding

• Discounting

• Present Values

• Future Values
 Compounding

Ascertain the value of an asset / project for tomorrow

Different compounding frequencies – yearly, quarterly, monthly

Effective Annualized Rates

 Discounting

Ascertain the value of an asset / project today

Different discounting frequencies – yearly, quarterly, monthly

Effective Annualized Rates

 Rates

• Risk Free Rate

• Debt

• Equity

• Weighted Average Cost of Capital

 Risk Free Rate

Government Security Bills

T – Bills

Use the G-Sec to compare based on the duration of the project

 Cost of Debt

Companies borrow to raise capital

Each time capital is raised or borrowed it comes with a cost

Higher the cost, higher the company has to earn to at least break even and then generate profits
 Cost of Equity

Companies sell stake to raise capital

Each time capital is raised or borrowed it comes with a cost

We use Capital Asset Pricing Model (CAPM) to ascertain the cost of equity
 Weighted Average Cost of Capital

Final cost of capital for the project

Weights of Debt and Equity times cost of debt and equity

This is the cost which each project has to recover

 Net Present Value

Now, that the cost of capital has been understood, let’s see how each project adds value to the company

Cost of starting the project + Benefits of all future cash flows discounted at today’s value
 Internal Rate of Return

There are 2 ways to look at IRR

- when the NPV = 0

- what is the return which the project is generating.

 Payback Period

How long does it take to recover the capital

The sooner, the better and the expected future cash flows after breakeven are profits and can be ploughed back
 Future Value (Key for DCF)

Businesses have multiple projects – each generating a different set of revenue streams at different growth rates

They have different costs – growing at different rates

Both revenue and costs are populated for a period of 5-7 years to arrive at different levels of profit

This is the EXPECTED profits of a company at different future points

 Present Value (Key for DCF)

Once we discount this future value to come to a valuation today – it is the present value of the company

This is the value which we finally divide by the number of shares in the market

If our value is lower than the market price, we conclude that the market is overpriced and the stock would fall

If our value is higher, we conclude that the market is under-priced and we buy the stock
Now, that we have understood
How to evaluate projects
We move towards
How to evaluate companies