Lesson 3 – GOING CONCERN ASSET BASED VALUATION

TOOLS Unit 1 – Financial Models

Overview:
Valuation process requires incorporation of a lot of factors that can be used to
facilitate the calculation. These help investors to enable to execute the formula and
fundamentals that are necessary to determine the value and at the same time to
determine the share from the company. And one of the tools that can also be used by
investors is financial model. This lesson will show how financial model is being
prepared.

Learning Objectives:
After successful completion of this lesson, you should be able to:
1. Define the financial models.
2. Describe the steps in developing a financial model.
3. Enumerate the components of financial model.

Course Materials:

Financial models are mathematical models designed to aid in coming up with a

recommended decision and at the same time can be used to validate the assumptions
made. It is similar to financial plan or quantification of strategies and operating plans of
the enterprise that is used to facilitate the following:
- Determination of asset value or enterprise value and equity value.
- Identification of risk.
- Development of scenarios and sensitivities.

Steps in developing a financial model:

1. Gather historical and material information - historical information may come from
audited financial statements where past performance of the company is
reported, from corporate disclosures which provide more context for the future
plans and strategies of the company, from contracts which shows the
covenants and existing agreements of the firm with other parties and peer
information that provides other researches and support
to identified risks from industry experts and other consultants.

2. Establish driver for growth and assumptions – drivers are data that have been
validated by government or experts. Growth drivers are based on population as
most of the products are consumer goods so the growth indicators may be
inflation, population growth, GNP or GDP growth. The bases may come from
different sources such as Philippine Statistics Authority (PSA), Bangko Sentral
ng Pilipinas (BSP), National Economic and Development Authority (NEDA) and
other government agencies.
n- 1 x 100%
Inflation = CPI CPIo
To illustrate, in year 2019, the CPI is 151 so the cost of the basket is PHP151. In
 year 2020, the CPI published is Php155. Since there is an increase of 4 from
2019 to 2020 CPI, there is an inflation of 2.64% using the equation above.

Financial ratios may be used as tools to determine the growth drivers

and assumptions. Trend analysis will also help you establish the trajectory of
growth pattern. The financial modeler must assess whether the company can
sustain the pattern otherwise, it is conservative to assume a less aggressive
growth. Normally, the weighted growth pattern will be considered in the long
term financial perspective. It must be assessed whether the average year on
year growth will be sustained or may be surpassed.
To illustrate, PIP Company’s historical production grows 10% per
year. It is expected that in the next five years, the probability are as
follows:
Scenario Rat e Probability
A 5% 10%
B 10% 40%
C 15% 50%

Given the data above, the weighted average growth rate to be used is
11.55% computed as follows:
Scenario Rat e Probability Weighted
A 5% 10% 0.5%
B 10% 40% 4.0%
C 15% 50% 7.5%
Total 11.55%

3. Determine the reasonable cost of capital – financial modeler must be able to

determine the appropriate cost of capital by weighing the portion of the asset
that is funded of equity and of debt. To do this, the weighted average cost of
capital (WACC). WACC = (Ke x We) + (Kd x Wd)
Ke – cost of equity
We – weight of the equity
financing Kd – cost of
debt after tax
Wd – weight of the debt financing

Ke = Rf + B (Rm – Rf)
Rf –risk free rate
B – beta
 Rm – market return

Kd = Rf + DM
Rf – risk free rate
DM – debt margin

To illustrate, the risk free rate is 5% and the prevailing interest rate
is 6%. The cost of debt is then 11%. Based on the current share of
financing, equity is 30% and debt is 70% while tax rate is 30%. Using the
formula above, the WACC is 10%.

4. Execute the formula to compute for the value – financial modeler usually use
DCF or Discounted Cash Flow in applying the capital budget techniques such
as Internal Rate of Return (IRR) or Net Present Value (NPV) for an instance.
Below example shows the computation and formula of NPV and IRR in
excel/spreadsheet.
In million pesos
1 2 3 4 5
Revenue 92.88 102.17 112.38 123.62 135.98
Less: Operating Expenses 65.01 71.52 78.67 86.53 95.19
(excluding Depreciation)
Less: Income Taxes Paid 8.13 9.19 10.11 11.13 12.24
Less: Capital Expenditures 100
Purchased
Net Cash Flow -80.26 21.46 23.6 25.96 28.55
Add: Terminal Value 285.5
Free Cash Flows -80.26 21.46 23.6 25.96 314.05

ultiply: Discount Factor (7%) 0.93 0.87 0.82 0.76 0.71

Discounted Free Cash Flows -74.6418 18.6702 19.352 19.7296 222.976

Free Cash Flows – Firm 206.09

Less: Outstanding Loans 50.00
Free Cash Flows - Equity 156.09
Net Present Value ₱206.72 =NPV(7
Internal Rate of Return 58% =IRR(B9

On the other hand, NPV and IRR may be computed manually using the
below formula: NPV = PV * (1/(1+i)n
PV – present value
I – interest
 n – number of years or period

5. Make scenarios and sensitivity analysis based on the result – a financial model
could easily be adjusted based on the perceived or desired result or
information on a given situation. Hence, the “what if analysis” can be done
using the financial model. For an instance, the 7% cost of capital may be 10%
or 12% and with the use of financial model, the results like the equity value can
easily be computed even when the sudden changes happen.

The scenarios may be presented in financial model based on the possible

occurrences like level of operating expense, mode of operations, capital
expenditure development. This is where Risk Based Valuation could actually
be used as it incorporates climate change, war, economic sabotage and
pandemic. While sensitivity analysis is almost similar to scenario modelling.
The only difference is that sensitivity analysis will have to select a driver or few
drivers, ceteris paribus, and check the degree of change it will cause to the
results. It is very useful in developing ballpark estimates. Ballpark figures are
quantitative drivers or multipliers that allow the investors to quickly make an
estimate or offer.

COMPONENTS OF FINANCIAL MODEL

1. Title Page
2. Data Key Results
3. Assumption Sheet
4. Pro-forma Financial Statements
5. Supporting Schedules