FINANCIAL MODELLING

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 FINANCIAL MODELLING

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Edited by:
Dr. Abhilash Ponnam
NMIMS Centre for Distance and Online Education
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iSBn:
978-93-91540-04-3

NMIMS Centre for Distance and Online Education

Address: V. L. Mehta Road, Vile Parle (W), Mumbai – 400 056, India. NMIMS Centre
 C O N T E N T S

CHAPTER NO. CHAPTER NAME PAGE NO.

1 Financial Modelling: An Overview 1

2 Corporate Valuation 51

3 Comparable Company Analysis 83

Case Studies
107
1 to 3

4 Discounted Cash Flow (DCF) Analysis 115

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Weighted Average Cost of Capital (WACC) 143
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6 Building an Integrated Cash Flow Model 189

Case Studies
219
4 to 6
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7 Pro Forma for Financial Statement Modelling 225

8 Portfolio Management 259

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9 Integrated Risk Modelling 297

Case Studies
321
7 to 9

10 Analysing and Concluding the Model 333

11 Variance-Covariance Matrix 365

12 Recruiting, Interviewing and Selection 393

Case Studies
427
10 to 12
iv

FI N AN CIAL M O DE LLI NG

C U R R I C U L U M

Financial Modelling: An Overview: Meaning of Modelling, Introduction to Excel, Understanding

Advanced Features of Excel, Functions in Excel, Trace Dependents and Trace Precedents, Micro-
soft Excel as the Modeller’s Tool, Uses of Financial Models, Role of Financial Modeller, Creating
Charts in Excel, Exploring Types of Charts, Creating a Chart, Resizing a Chart, Moving a Chart,
Copying and Pasting a Chart. Converting a Chart Type into Another Chart Type, Printing a Chart,
Understanding Finance Functions Present in Excel, Creating Dynamic Modelling, Steps in Dynam-
ic Modelling, Data Validation

Corporate Valuation: Meaning of Valuation, mportance of Valuation, Understanding Enterprise

Value and Equity Value, Present Value and Net Present Value, The Internal Rate of Return (IRR)
and Loan Tables, Multiple Internal Rates of Return, Flat Payment Schedules, Future Values and
Applications, A Pension Problem—Complicating the Future Value Problem, Continuous Com-
pounding
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Comparable Company Analysis: Introduction to Comparable Company Analysis, Selecting Com-
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parable Companies, Spreading Comparable Companies, Analysing the Valuation Multiples, Con-
cluding and Understanding Value, Introduction to Precedent Transactions Analysis, Selecting
Comparable Transactions, Spreading Comparable Transactions, Concluding Value, Four Methods
to Compute Enterprise Value (EV), Using Accounting Book Values to Value a Company, The Firm’s
Accounting Enterprise Value, The Efficient Markets Approach to Corporate Valuation, Enterprise
Value (EV) as the Present Value of the Free Cash Flows
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Discounted Cash Flow (DCF) Analysis: Discounted Cash Flow (DCF) Analysis, Understanding
Unlevered Free Cash Flow, Forecasting Free Cash Flow, Forecasting Terminal Value, Present Value
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and Discounting, Understanding Stub Periods, Analysis of bonds and swaps, Performing Sensitivity
Analysis, Cash Flows: DCF “Top Down” Valuation, Consolidated Statement of Cash Flows (CSCF),
Free Cash Flows Based on Consolidated Statement of Cash Flows (CSCF), Free Cash Flows Based
on Pro Forma Financial Statements

Weighted Average Cost of Capital (WACC): Weighted Average Cost of Capital (WACC), Using the
CAPM to Estimate the Cost of Equity, Estimating the Cost of Debt, Understanding and Analysing
WACC, Concluding Valuation, Computing the Value of the Firm’s Equity, E, Computing the Value
of the Firm’s Debt, D, Computing the Firm’s Tax Rate, TC, Computing the Firm’s Cost of Debt, rD,
Two Approaches to Computing the Firm’s Cost of Equity, rE, Implementing the Gordon Model for
rE, The CAPM: Computing the Beta, Using the Security Market Line (SML) to Calculate Merck’s,
Cost of Equity, Ke/Ri. Computing the WACC, Three Cases, Computing the WACC for Merck (MRK),
Computing the WACC for Whole Foods (WFM), Computing the WACC for Caterpillar (CAT)

Building An Integrated Cash Flow Model: Building an Integrated Cash Flow Model, Use Automa-
tion to Improve Your Forecasting Model’s Reliability, Summary: How to Create a Cash Flow Fore-
 v

cast in Excel, Understanding Circularity, An alternative approach to solving circular interest, Using
algebra to solve circular interest, Setting up and Formatting the Model, A Consistent Colour Scheme,
Exact Figures in Financial Model Formatting, Text with Custom Formatting, Financial Model Format-
ting Matters, Selecting Model Drivers and Assumptions, Model Tab: Detailed Calculations and Oper-
ating Build-up, Creating the Debt and Interest Schedule, Free Cash Flow (FCF): Measuring the Cash
Produced by the Business, Merck: Reverse Engineering the Market Value

Pro Forma for Financial Statement Modelling: Meaning of Financial Statement Modelling, Modelling
and Projecting the Financial Statem, Projecting the Income Statement, Projecting the Balance Sheet,
Projecting the Cash Flow Statement, Drafting Cash Flow Projection, How Financial Models Work, Pro-
jecting Next Year’ s Balance Sheet and Income Statement, Alternative Modelling of Fixed Assets, Gross
Fixed Assets as a Function of Sales, Constant Net Fixed Assets, Sensitivity Analysis, Debt as a Plug, In-
corporating a Target Debt/Equity Ratio into a Pro Forma, Project Finance: Debt Repayment Schedules,
Calculating the Return on Equity, The ROE in Our First Full Model, Tax Loss Carry Forwards

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Portfolio Management: Turning Your Goals into a Strategy, Risk-reward Ratio, Investment Risk Pyr-
amid, Portfolio Strategies, Building an Investment Portfolio, Risk Reduction in the Stock Portion of a
Portfolio, Value Investing, Growth Investing
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Integrated Risk Modelling: Meaning of Risk Modelling, The Model, General Risk, Credit Risk, Oper-
ational Risk, Market Risk, Implementation, Simulation Procedure, Simulation Variability, Empirical
Results
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Analysing And Concluding The Model: Revolver Modelling, How does a revolver work in a 3-state-
ment model? Revolvers are secured by accounts receivable and inventory, Analysing the Output, Stress
Testing the Model, Error Checking, Types of Stress Testing, Fixing Modelling Errors, The Model Re-
view Process, Seven Types of Errors, Advanced Modelling Techniques, Using the Model to Create a
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Discounted Cash Flow (DCF) Analysis, DCF Model Basics: Present Value Formula, How to Build a DCF
Model: 6 Step Framework

Variance-Covariance Matrix: Sample Variance-Covariance Matrix, Fixed-Weight Historical, Expo-

nential Smoothing, Multivariate GARCH, The Correlation Matrix, Computing the Global Minimum
Variance Portfolio (GMVP), Alternatives to the Sample Variance-Covariance, The Single-Index Model
(SIM), Constant Correlation, Shrinkage Methods, Using Option Information to Compute the Variance
Matrix

Recruiting, Interviewing and Selection: Recruiting and Interviewing, Financial Institutions and In-
vestment Banks, Process of Interviewing, General Interviewing Overview, Qualitative/fit Questions,
Technical Questions, Post Interview, Following up, Selecting a Firm, Selecting a Group, Investment
Banking, Selection, How to Hire Financial Advisors?
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 C H A
1 P T E R

FINANCIAL MODELLING: AN OVERVIEW

CONTENTS

1.1 Introduction
1.2 Meaning of Modelling

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Self Assessment Questions
Activity
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1.3 Introduction to Excel
1.3.1 Understanding Advanced Features of Excel
1.3.2 Functions in Excel
1.3.3 Trace Dependents and Trace Precedents
Self Assessment Questions
Activity
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1.4 Microsoft Excel as the Modeller’s Tool

1.4.1 Uses of Financial Models
1.4.2 Role of Financial Modeller
Self Assessment Questions
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Activity
1.5 Creating Charts in Excel
1.5.1 Exploring Types of Charts
1.5.2 Creating a Chart
1.5.3 Resizing a Chart
1.5.4 Moving a Chart
1.5.5 Copying and Pasting a Chart
1.5.6 Converting a Chart Type into Another Chart Type
1.5.7 Printing a Chart
Self Assessment Questions
Activity
1.6 Understanding Finance Functions Present in Excel
Self Assessment Questions
Activity
1.7 Creating Dynamic Modelling
1.7.1 Steps in Dynamic Modelling
2 FINANCIAL MODELLING

CONTENTS

1.7.2 Data Validation

Self Assessment Questions
Activity
1.8 Summary
1.9 Multiple Choice Questions
1.10 Descriptive Questions
1.11 Higher Order Thinking Skills (HOTS) Questions
1.12 Answers and Hints
1.13 Suggested Readings & References

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 FINANCIAL MODELLING: AN OVERVIEW 3

INTRODUCTORY CASELET

FINANCIAL MODELLING

Based on a company’s previous performance and predictions of

future income, costs and other factors, financial modelling is a Case Objective
technique for projecting likely financial outcomes. Financial mod- This caselet explains
elling, which mimics a forecast’s assumptions using a company’s the overview of financial
financial statements to show how those statements may seem in modelling.
the future, is built on financial projections. Since they are con-
structed using financial data, models usually offer results for a
month, quarter or year.

The bulk of financial models are made on Excel spreadsheets and

need human data entry. One of the simplest variants, known as
the three-statement model, just requires an income statement,
balance sheet, cash flow statement and any associated schedules.
Due to the vast range of uses for them, some versions are far more

nesses to meet their demands.

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advanced than others. Models are routinely modified by busi-

There is software that helps users to optimise forecasting esti-

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mates with the help of a thorough, already-built statistical model-
ling engine. The model can provide predictions for future finan-
cial results and enable users to integrate them immediately into
their plan or projection using an industry-accepted statistical
model. You may edit data on your own by combining this tool with
spreadsheet apps such as Excel. Without your assistance, it can
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also automatically analyse your historical data using pre-built

algorithms to provide financial estimates.
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4 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

> Explain the meaning of modelling
> Discuss the introduction to Excel
> Describe the advanced features of Excel
> Summarise the Microsoft excel as the modeller’s tool
> Classify the financial functions present in Excel

1.1 INTRODUCTION
Building spreadsheet models to quantitatively depict a company’s
Know More expected financial outcomes is known as financial modelling. The act
The technique of evaluating of creating a financial representation of all or partial features of a com-
the financial performance of pany or specific securities is known as financial modelling. The model
a project or corporation using
all pertinent variables, growth
and risk assumptions, and
analysing their effects is known
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is often known for doing computations and giving advice based on
such data. The model may also serve as a summary for specific events
for the user, such as the Sortino ratio or investment management
returns, or it may be used to predict market direction, such as the Fed
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as financial modeling. It makes
it possible for the user to quickly model. A mathematical depiction of a company’s financial activities
get knowledgeable about all and financial statements is called a financial model. Making pertinent
the factors involved in financial assumptions about the company’s performance in the upcoming fiscal
forecasting. years is used to anticipate the company’s future financial success.

It may be used as a risk management tool to analyse different financial

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and economic situations and offer asset assessments. These models

do computations, analyse the results and then offer suggestions based
on the data acquired. In financial models, financial statements such
as the income statement, balance sheet and cash flow statement are
projected using schedules such as depreciation schedules, amortisa-
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tion schedules, working capital management and debt schedules. It

includes all corporate rules and constraints imposed by lenders that
could affect the financial situation.

In this chapter, you will study the meaning of modelling, introduction

to Excel, understand the advanced features of Excel, Microsoft Excel
as the modeller’s tool, create charts using forms and control toolbox,
understand finance functions present in Excel, create dynamic mod-
elling, steps in dynamic modelling, etc., in detail.

1.2 MEANING OF MODELLING

The method through which a company creates a financial representa-
tion of some, all or neither of its characteristics or a particular security
is modelling. The model is often known for making computations and
giving advice based on the results. The model may also give guidance
for potential actions or alternatives and describe specific occurrences
for the end user.
 FINANCIAL MODELLING: AN OVERVIEW 5

Financial modelling is the process of compiling a spreadsheet-based

overview of a company’s costs and profits that may be used to estimate NOTE
the effects of a potential event or choice. Building a model from scratch
or updating an existing model
For business leaders, a financial model has various applications. It with newly accessible data are
the two options for financial
is most frequently used by financial analysts to assess and forecast modeling. As you can see,
the potential effects of upcoming events or management choices on a all of the financial scenarios
company’s stock performance. mentioned above are intricate
and unstable. It aids the
Financial modelling is the process of using numbers to describe the user in fully comprehending
every element of the intricate
activities of a business in the past, present and anticipated future. circumstance.
These models are designed to be instruments for making decisions.
They could be used by company leaders to predict the expenses and
profitability of a proposed new project.

Using them, analysts can explain or forecast how events, such as

changes in strategy or business model and economic policy changes,
may affect a company’s stock price.

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Financial models are employed when attempting to value a com-
pany or when contrasting it with others in the same sector. They are
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also employed in strategic planning to evaluate potential outcomes,
determine project costs, establish budgets and distribute resources
throughout the organisation.

SELF ASSESSMENT QUESTIONS

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1. Which of the following is the process of compiling a

spreadsheet-based overview of a company’s costs and profits?
a. Financial modelling
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b. Capital budgeting
c. Time value of money
d. None of these
2. Which of the following uses financial modelling to explain
or forecast how certain events, including internal ones and
external ones?
a. Financial accountants
b. Financial analysts
c. Financial models
d. All of these

ACTIVITY

Note the advantages of financial modelling.

 DID YOU KNOW
Apart from MS Excel, some
other spreadsheet applications
available in the market are:
OpenOffice Calc
LibreOffice Calc
Google Sheets
Gnumeric
Kingsoft Spreadsheets
NOTE
You can create a blank workbook
by pressing the Ctrl + N keys
from the keyboard.
NOTE
While working with different
applications of Microsoft Office,
some users may see Search in
place of Tell me what you want
to do in the Ribbon. Please note
that the working of both the
Search option and the Tell me
what you want to do option is
same.
click

NOTE
You can also provide a range of
cells in the SUM function. For
example, if you write =SUM (A1:
A9), then the SUM() function
adds the numbers present in the
cells range from A1 to A9.
 MARK IT!
Using the SUMIF() function
to match strings more than
255 characters long will give
incorrect results.
NOTE
You can use wildcard characters
such as question mark (?) for
matching any single character
and an asterisk (*) for matching
any series of characters in the
SUMIF() and SUMIFS() functions.
 MARK IT!
In the SUMIFS() function, you
can enter up to 127 range/
criteria pairs.

TURN TO THE
WEB
You can learn more about
formulas and functions using the
following link:

[Link]
com/en-us/office/formulas-
andfunctions-294d9486-b332-
48edb489-abe7d0f9eda9?ui=en-
US&rs=en-US&ad=US
14 FINANCIAL MODELLING

Examples
In the example blow in figure 1.1, the formula in B4 is:
=SEQUENCE(10,5,0,3)

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With this configuration, SEQUENCE returns an array of sequential
numbers, 10 rows by 5 columns, starting at zero and incremented
by 3. The result is 50 numbers starting at 0 and ending at 147, as
shown in the screen.
SEQUENCE can work with both positive and negative values.
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To count from -10 to zero in increments of 2 in rows, set rows to 6,

columns to 1, start to -10, and step to 2:
=SEQUENCE(6,1,-10,2) // returns {-10;-8;-6;-4;-2;0}
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To count down between 10 and zero:

=SEQUENCE(11,1,10,-1) // returns {10;9;8;7;6;5;4;3;2;1;0}
Because Excel dates are serial numbers, you can easily use
SEQUENCE to generate sequential dates. For example, to
generate a list of 10 days starting today in columns, you can use
SEQUENCE with the TODAY function.
=SEQUENCE(1,10,TODAY(),1)

TEXT FUNCTIONS

Most people think of MS Excel as an application that is only used to

handle numeric data. While it is true that MS Excel provides several
features that make working with numbers easy, the application is also
found to be equally helpful for manipulating textual data. To work
with text, MS Excel provides a special set of functions known as text
functions. These functions can be used to control the way text appears
on a worksheet. These text functions can be easily accessed from the
NOTE
The standard deviation is a way
of finding out how widely values
are distributed from the average
value (or mean).
 MARK IT!
You can draw a trend line by
using the line chart.
NOTE
If array1 and array2 contain
different number of data points,
the CORREL() function returns
the #N/A error.
reference
 FINANCIAL MODELLING: AN OVERVIEW 19

press F2, and then press Enter. If you need to, you can adjust the col-
umn widths to see all the data.

Formula Description Result

=TODAY() The formula in C2 returns the formula =FORMULA-
it finds in cell A2 as a text string so that TEXT(A2)
you can easily inspect its structure. The
formula entered in A2 is =TODAY(), and
will return the current day in A2. The
formula =TODAY() should appear as text
in C2.

1.3.3 TRACE DEPENDENTS AND TRACE PRECEDENTS

To find the cells that contain the formula in Excel, utilise trace prec-
edents and trace dependents. The cells that influence the value of
the active cell are shown in Trace Precedents, while the cells that are
impacted by the active cell are shown in Trace Dependents. Tracer

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arrows can be used to spot trace predecessors and trace dependents.

Example: In this case, there are two tables as shown in figure 1.2.
Employee ID and sales are contained in one table, while Employee ID
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and tax are contained in the other table. We have calculated the total
of each table item’s corresponding value in cells C9 and C16. Then,
C5:C8 are examples of C9, and C12:C15 are examples of [Link]’s see
how will we trace precedents here. The steps for performing trace
precedent are as follows:
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1. Select the cell that contains the formula whose precedents you
want to trace, as shown in Figure 1.2:
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Figure 1.2: Selecting the Cell

20 FINANCIAL MODELLING

2. Click the Trace Precedents button under the Formula Auditing

group in the Formulas tab, as shown in Figure 1.3:

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Figure 1.3: Clicking the Trace Precedents button
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Once you click Trace Precedents, the tracer arrows will show the
cells that affect the active cell’s value as shown Figure 1.4:
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Figure 1.4: Trace Precedents Cells

 FINANCIAL MODELLING: AN OVERVIEW 21

3. Repeat steps 1 and 2 to show that C12:C15 are precedents of C16

as shown in Figure 1.5:

Figure 1.5: Trace Precedents

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Example: In this case, there are two tables. Employee ID and sales
are contained in one table, while Employee ID and tax are contained NOTE
in the other table. We have calculated the total of each table item’s The cell at one end of the line is
corresponding value in cells C9 and C17. We have deducted C17 from activated by double-clicking a
C9 in cell F11. In that instance, cells C9 and C17 are necessary for F11. tracer arrow.
Let’s see how will we trace dependents here. The steps for performing
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trace dependents are as follows:

1. Select the cell that contains the formula whose dependent cells
you want to trace, as shown in Figure 1.6:
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Figure 1.6: Selecting the Cell

22 FINANCIAL MODELLING

2. Click the Trace Dependents button under the Formula Auditing

group in the Formulas tab, as shown in Figure 1.7:

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Figure 1.7: Clicking the Trace Dependents button
Once you click Trace Dependents, the tracer arrows will
show the cells that are affected by the active cell as shown in
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Figure 1.8:
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Figure 1.8: Affected Cells in Trace Dependents

 FINANCIAL MODELLING: AN OVERVIEW 23

3. Repeat steps 1 and 2 to show that cell F11 is dependent on the

cell C9 and also with C17 as shown in Figure 1.9:

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Figure 1.9: Trace Dependents

SELF ASSESSMENT QUESTIONS

NOTE
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Choose the Remove Arrows

3. The _________ function allows you to predict exponential button, which is located just
growth based on a given set of data. below the Trace Dependents
button, if you wish to remove the
a. MEDIAN arrows.
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b. STDEVA
c. GROWTH
d. AVERAGE
4. Which of the following functions is used to count the number
of cells within a range that meet the given condition?
a. COUNT
b. COUNTIF
c. COUNTIFS
d. None of these

ACTIVITY

Find some more features of MS Excel.

 DID YOU KNOW
Instead of working on a blank
template, you can use sample
templates provided by MS Excel.

QUICK TIP
In case, you do not find a
template matching to your
requirements, you can search
for more templates on the
Microsoft website.
 DID YOU KNOW
The File tab is located below the
Quick Access Toolbar.
NOTE
Here is a list of the 10 most
common types of financial
models:
Three Statement Model
Discounted Cash Flow (DCF)
Model
Merger Model (M&A)
Initial Public Offering (IPO)
Model
Leveraged Buyout (LBO)
Model
Sum of the Parts Model
Consolidation Model
Budget Model
Forecasting Model
Option Pricing Model
 MARK IT!
A chart is one of the ways to
represent and analyse data
visually.

DID YOU KNOW

In a column chart, the vertical
axis represents a value
scale and the horizontal axis
represents various categories
that are measured against the
value scale.
Open

Select

Select

Select
 FINANCIAL MODELLING: AN OVERVIEW 31

The selected chart is created on the worksheet, as shown in

Figure 1.13:

Figure 1.13: Displaying the 3-D 100% Stacked Column Chart

1.5.3 RESIZING A CHART

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If you want to change the size of your chart, you can do so by simply
selecting the chart. On selecting the chart, eight handles appear on
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the border of the chart. Now, place the mouse pointer on any of these
handles and drag it to resize the chart. You can resize a chart by per-
forming the following steps:
1. Open a new or an existing workbook that contains the chart you
want to resize.
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2. Click anywhere on the chart. Eight handles appear on the border

of the chart.
3. Move the mouse pointer over any of these handles. In our case,
we have moved the mouse pointer over the middle handle at the
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bottom of the chart.

4. Drag the mouse pointer to set the chart as per the desired size, as
shown in Figure 1.14:

Figure 1.14: Resizing the Chart

32 FINANCIAL MODELLING

5. Release the mouse button. The chart is resized, as shown in

Know More Figure 1.15:
When you select a chart, the
Chart Tools contextual tab
appears on the Ribbon with
Design and Format tabs.

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Figure 1.15: Displaying the Resized Chart
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EXHIBIT

Formatting Paint Brush

Formatting pain brush is one of the most underused features

of Excel. The Format Painter copies formatting from one place and
applies it to another.
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1. Select cell B2, as shown in Figure A:

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Figure A: Selecting the Cell B2

2. Click the Format Painter button under the Clipboard group
in the Home tab. A moving dashed border appears around cell
B2 and the mouse pointer changes to a plus and a paintbrush,
as shown in Figure B:

Figure B: Displaying the Paintbrush

 FINANCIAL MODELLING: AN OVERVIEW 33

3. Select the cell D2 to apply formatting, as shown in Figure C: NOTE

The Format Painter applies the
Currency format, background
colour and borders of cell B2 to
cell D2. That saves time! Instead
of selecting cell D2, you can also
select a range of cells to apply
the format of cell B2 to a range
Figure C: Selecting the Cell D2 of cells.

4. Double click the Format Painter button to apply the same

formatting to cells multiple times.

1.5.4 MOVING A CHART

When you create a chart in MS Excel, it appears in the middle of your

workbook by default. Sometimes, the chart hides the data in the work- NOTE
sheet.

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Therefore, to ensure that both the data and the chart are visible in
the worksheet, you need to correctly align the chart with the data. For
Click the Format Painter button
again (or press Esc) to exit
Format Painter mode.
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this, you need to move the chart to a new location within the same
worksheet. Perform the following steps to move a chart:
1. Open a new or an existing workbook that contains the chart you
want to move.
2. Click anywhere on the chart to display the borders around it.
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3. Click and drag the border to move the chart to the desired
location in the worksheet.
4. Release the mouse button. The chart is moved to the new location.
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1.5.5 COPYING AND PASTING A CHART

Sometimes, you may need a copy of a chart within the same work-
sheet or a different worksheet. In such a case, instead of making the
same chart from scratch again, you can copy that chart and paste it to
the desired location on the worksheet.

You can copy and paste a chart by performing the following steps:
1. Select the chart that you want to copy.
2. Click the Copy button under the Clipboard group of the Home
tab.
3. Select the location where you want to paste the chart.
4. Click the Paste button under the Clipboard group of the Home
tab.

The copied chart is pasted at the selected location.

34 FINANCIAL MODELLING

1.5.6 CONVERTING A CHART TYPE INTO ANOTHER CHART

TYPE

Suppose you find that your data does not suit the chart that you have
created. In such cases, MS Excel provides you with the facility to
switch to another chart type that suits your data.

You can convert a chart type into another chart type by performing
the following steps:
1. Select the chart that you want to convert.
2. Click the Change Chart Type button under the Type group of the
Design tab in the Chart Tools contextual tab. The Change Chart
Type dialogue box appears with the All Charts tab selected by
default.
3. Select a chart category from the list of chart category names
displayed on the left side of the dialogue box. In our case, we

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have selected the Bar category.
4. Select a chart type from the list of available chart types. In our
case, we have selected the Clustered Bar chart type.
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5. Click the OK button, as shown in Figure 1.16:
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Figure 1.16: Selecting the Chart Type

 DID YOU KNOW
By default, the legend is
displayed at the bottom side of
Select the chart.
36 FINANCIAL MODELLING

2. Select the File tab. The Backstage View appears.

3. Select the Print option on the Backstage View.
4. Type the desired value in the Copies spin box. In our case, we
have typed the value as 1.
5. Click the Print button to print the chart, as shown in Figure 1.18:

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Figure 1.18: Setting the Print Options

SELF ASSESSMENT QUESTIONS

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7. Which of the following charts is used to show data in the form

of frequency within a distribution?
a. Histogram
b. Funnel
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c. Waterfall
d. Treemap

ACTIVITY

Find some more advanced features of MS Excel.

UNDERSTANDING FINANCE FUNCTIONS

1.6
PRESENT IN EXCEL
The financial functions provided in MS Excel help you to perform
financial calculations, such as calculating the monthly payment of a
loan or an investment, the interest earned on security and the future
value of an investment or a loan. Financial functions are primarily
used by accountants, financial institutions and insurance companies.
In MS Excel, you can access the financial functions by clicking the
 MARK IT!
The rate of interest is divided
by 12 to get the monthly rate of
interest and the annual amount
is multiplied by 12 to get the total
payment to be made.
NOTE
UML stands for Unified
Modelling Language used to
specify, visualise, construct,
and document the artefacts of
software systems.
Open
 FINANCIAL MODELLING: AN OVERVIEW 43

2. Select the cell or cell range where you want to apply data
validation.
3. Click the Data Validation button under the Data Tools group in
the Data tab.
The Data Validation dialog box appears, with the Settings tab
activated by default.
4. Click the down arrow button of the Allow drop-down list.
A drop-down list appears.
5. Select an option from the drop-down list to specify the type of
data validation you want to apply. In our case, we have selected
the Whole number option
6. Click the down arrow button of the Data drop-down list.
A drop-down list appears.

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7. Select an option from the drop-down list to specify the criteria
for data validation. In our case, we have selected the less than
option.
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When you select the less than option in the Data drop-down list,
the Maximum text box appears in the Data Validation dialog
box.
8. Enter a value in the Maximum text box to specify the highest
whole number that you want to set for the selected criteria.
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9. Click on the Input Message tab.

10. Type a title in the Title text box to specify the title for the input
message box that appears when you enter data in the required
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cell.
11. Type the message in the Input message text area, which is
displayed in the input message box to guide the user to enter
correct data.
12. Click on the Error Alert tab
13. Type a title in the Title text box to specify the title for error
message box.
14. Type the error message that you want to display when a user
makes an invalid entry, in the Error message text area.
15. Click the OK button to save the settings.
16. Enter a value in the area you selected for validation in the
worksheet.
17. Press the ENTER key to check whether the value you entered is
valid or not.
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46 FINANCIAL MODELLING

2. Which of the following offers thesaurus functionality, spelling

checks, text translation and tools for sharing and protecting
worksheets and workbooks?
a. Review b. View
c. Page layout d. None of these
3. The user may utilise a variety of built-in formulas and functions
by simply selecting a cell or cell range as the source of the value.
Which of the following option is correct regarding the above
statement?
a. Data b. Formulas
c. View d. Review
4. Which of the following is called a potent collection of Excel
formulae that will advance your financial analysis and financial
modelling?

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a. Index match
c. XNPV and XIRR
b. IF combined with AND/OR
d. SUMIF and COUNTIF
5. These two complex equations are excellent examples of
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conditional functions in practice. All cells that satisfy specified
requirements are added by SUMIF, and all such cells are counted
by COUNTIF. Which of the following option is correct regarding
the above statement?
a. IF combined with AND/OR
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b. XNPV and XIRR

c. Index match
d. SUMIF and COUNTIF
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6. Which of the following formula uses the terms rate, number of

periods and present value?
a. PMT b. IPMT
c. EFFECT d. RATE
7. Which of the following refers to the use of numerous tools to
analyse financial statements, such as the income statement,
balance sheet and cash flow statement?
a. Assumptions
b. Planning
c. Financial statement analysis
d. Forecasting
8. The firm may be appraised utilising the Discounted Cash Flow
(DCF) analysis technique after the forecast has been created.
 FINANCIAL MODELLING: AN OVERVIEW 47

Which of the following option is correct regarding the above

statement?
a. Forecast
b. Ratios & Metrics
c. Historical data
d. Valuation
9. Identify the role of the financial modeller.
a. Financial modelling’s importance in the finance sector is ris-
ing quickly.
b. Financial models are mathematical expressions used to de-
pict the financial performance of an organisation.
c. Both a. and b.
d. Making strategic plans and decisions.

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10. Which of the following captures the control factors that allow
the behaviour of objects to be understood throughout time and
depicts the temporal features of a system?
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a. Financial modelling
b. Dynamic modelling
c. Financial analysis
d. None of these
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1.10 DESCRIPTIVE QUESTIONS

1. Discuss the meaning of modelling.
?
2. Explain the brief introduction to Excel.
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3. Describe Microsoft Excel as the modeller’s tool.

4. Explain the role of the financial modeller.

HIGHER ORDER THINKING SKILLS

1.11
(HOTS) QUESTIONS
1. You are thinking about investing in a start-up business with an
original, creative idea. How will you begin?
a. Determine if the investment will bring in enough money to be
profitable.
b. Consider the company’s sources and expenditures of cash.
c. Determine how much debt is incurred in the investing pro-
cess.
d. Inspect the company’s balance sheet and goodwill.
48 FINANCIAL MODELLING

2. Naman is an accountant in a firm that provides financial services.

The manager asks Naman to calculate the estimated future value
of the investment based on the fixed interest rate and a fixed
payment. Which function of MS Excel helps Naman to do this
task?
a. PV() function
b. FV() function
c. NPER() function
d. RATE() function
3. What does a toggle mean as it relates to an Excel financial model?
a. It is a cell that tests sensitivity by switching inputs for out-
puts.
b. It is a formula that, depending on presumptions, generates a
yes or no decision.

ues. S
c. In Excel, it’s a simple way to switch between several cell val-

d. It is a simple approach to altering the model’s underlying sce-

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nario as a whole.

1.12 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

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Topic Q. No. Answer

Meaning of Modelling 1. a. Financial modelling
2. b. Financial analysts
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Introduction to Excel 3. c. GROWTH

4. c. COUNTIF
Microsoft Excel as the modeller’s tool 5. b. Forecasting
6. a. Assumptions
Creating Charts Using Forms and 7. a. Histogram
Control Toolbox
Understanding Finance Functions 8. b. RATE
Present in Excel
9. d. FV
Creating Dynamic Modelling 10. b. Transitions
11. c. Actions

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. c. Insert Tab
 FINANCIAL MODELLING: AN OVERVIEW 49

Q. No. Answer
2. a. Review
3. b. Formulas
4. a. Index match
5. d. SUMIF and COUNTIF
6. a. PMT
7. c. Financial statement analysis
8. d. Valuation
9. c. Both a. and b.
10. b. Dynamic modelling

ANSWERS FOR DESCRIPTIVE QUESTIONS

1. The method through which a company creates a financial
representation of some, all or neither of its characteristics or

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a particular security. The model is often known for making
computations and giving advice based on the results. The model
may also give guidance for potential actions or alternatives and
describe specific occurrences for the end user.
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Financial modelling is the process of compiling a spreadsheet-
based overview of a company’s costs and profits that may be
used to estimate the effects of a potential event or choice. Refer
to Section 1.2 Meaning of Modelling
2. Microsoft Office program includes MS-EXCEL. It is an
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electronic spreadsheet with many rows and columns that is used

for data organisation, graphic data representation and other
computations. A cell is made up of a row and a column, which
together make up one of its 1048576 rows and 16,384 columns.
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The address of each cell is determined by the name of the column

and the row, for example, A1, D2, etc. Another name for this is a
cell reference. Refer to Section 1.3 Introduction to Excel
3. One of the most sought-after yet poorly understood abilities in
finance is financial modelling. The objective is to incorporate
accounting, finance and business elements to create an
Excel forecast that represents an organisation in an abstract,
projected way. It may be quite difficult to predict a company’s
activities in the future. Every company is different and needs a
highly specialised set of calculations and assumptions. Excel is
employed since it is the tool that can be customised and is the
most adaptable. Software, on the other hand, might be overly
restrictive and hinder your ability to comprehend each line of
the business the way Excel does. Refer to Section 1.4 Microsoft
Excel as the Modeller’s Tool
4. The technique of utilising numbers to represent a business’s
past, current and predicted future actions is known as financial
 C H A
2 P T E R

CORPORATE VALUATION

CONTENTS

2.1 Introduction
2.2
2.2.1
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Meaning of Valuation
Importance of Valuation
Self Assessment Questions
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Activity
2.3 Understanding Enterprise Value and Equity Value
Self Assessment Questions
Activity
2.4 Present Value and Net Present Value
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Self Assessment Questions

Activity
2.5 The Internal Rate of Return (IRR) and Loan Tables
Self Assessment Questions
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Activity
2.6 Multiple Internal Rates of Return
Self Assessment Questions
Activity
2.7 Flat Payment Schedules
Self Assessment Questions
Activity
2.8 Future Values and Applications
Self Assessment Questions
Activity
2.9 A Pension Problem—Complicating the Future Value Problem
Self Assessment Questions
Activity
2.10 Continuous Compounding
Self Assessment Questions
Activity
52 FINANCIAL MODELLING

CONTENTS

2.11 Summary
2.12 Multiple Choice Questions
2.13 Descriptive Questions
2.14 Higher Order Thinking Skills (HOTS) Questions
2.15 Answers and Hints
2.16 Suggested Readings & References

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 CORPORATE VALUATION 53

INTRODUCTORY CASELET

BUSINESS VALUATION CASE STUDY: CASH FLOW IS KING

The significance of cash flow available to an investor or business

buyer has been emphasised in a number of my earlier writings Case Objective
on business valuation. I think the main factor used to determine
value in the majority of business appraisals should be this metric This caselet highlights the
valuation of business based
of cash flow. I was hired a few years ago to assist in figuring out
on cash flows.
the worth of a sole proprietorship’s 100% ownership stake for use
in marital breakdown proceedings. The worth of the company for
the purposes of asset dissolution had to be determined by the val-
uators for both parties. The court procedures and a comparison of
the valuation techniques employed by the two parties provide a
compelling illustration of the significance of cash flow in estimat-
ing a company’s worth.

CASE BACKGROUND

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The company in question was a one-person operation that offered
“sales, repair, and installation” services to residences and com-
mercial establishments. The company was housed in a 2,500
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square foot store in the owner’s home. The company paid a tiny
compensation to the owner’s spouse but did not pay rent for the
use of the premises or a salary for the owner’s services. Although
the company maintained a steady stream of customers, its profit-
ability changed from year to year.
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APPROACHES USED

In order to assess the worth of the company, the opposing val-

uation expert (Expert A) only used the Privately Traded Guide-
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line Company Method. In order to look for deals involving busi-

nesses thought to be comparable to the subject business, Expert
A searched the Pratt’s Stats –— Private Company Merger and
Acquisition database. Expert A discovered 38 transactions involv-
ing businesses thought to be comparable to the subject firm using
search parameters, including similar NAICS codes, a comparable
range of revenue, and a timeframe of the prior 10 years to the effec-
tive date of the valuation. Expert A calculated the mean (average)
sales multiple as 0.73 using these 38 transactions. The projected
enterprise value of the company was then calculated by Expert A,
who multiplied this sales multiple by the average of the preceding
three years’ sales to arrive at a figure of almost $432,000.

I used the same historical data as Expert A’s valuation and the pri-
vately traded guideline company method, but I also made normal-
isation adjustments to the income statements to account for the
shop’s market rate rent expense, the owner’s estimated market
54 FINANCIAL MODELLING

INTRODUCTORY CASELET

level compensation based on services rendered, and any compen-

sation paid to the spouse that would not be necessary for the busi-
ness’ operation. Along with other search parameters, I also used
the Pratt’s Stats database. I found 40 transactions in my search,
including the 38 transactions that Expert A utilised. Additionally,
I selected the sales multiple and the Seller’s Discretionary Earn-
ings (SDE) multiple as the two multiples to employ in my valua-
tion. SDE is defined as Operating Profit (Earnings Before Interest
and Taxes) plus Owners Compensation plus Depreciation/Amor-
tisation in Pratt’s Stats FAQ. The most pertinent multiple, in my
opinion, is SDE since it closely mirrors the earnings stream that a
buyer of the company would have access to.

I determined the subject firm’s normalised SDE (taking into

account the normalisation changes previously described) before
determining the SDE as a percentage of sales for the subject com-

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pany. The SDE as a percentage of sales for the transactions in
my search was then contrasted with this proportion. The findings
showed that the normalised SDE as a percentage of sales for the
subject firm was close to the SDE as a percentage of sales in the
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21st percentile of the transactions in my search. The transactions’
related 21st percentile SDE multiple was 1.93 times SDE. I also
estimated the 21st percentile’s sales multiple, which came out to
be 0.41 times revenue. The outcome of calculating the estimated
enterprise value of the company using these two multiples was
about $145,000.
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ANALYSIS

My strategy took into account the bottom-line cash flow that a

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prospective buyer of the firm would have access to and utilised

multiples matching to deal with comparable levels of cash flow.
In my study, I made the point that top-line profitability indicators
such as revenue should be accompanied with an analysis demon-
strating how they relate to cash flow indicators at the bottom-line.
Simply put, the bottom-line cash flow that a business buyer would
have access to should be close to the “mean” cash flow of the data
set if the “mean” multiple for revenue is to be applied. It didn’t in
these transactions, and I thought a different multiple ought to be
used.

FINDINGS

The judge in the case heard arguments from both parties and
requested that a third independent valuation expert analyse
both reports and inform the court which strategy they thought
was more credible because of the discrepancy in the outcomes.
 CORPORATE VALUATION 55

INTRODUCTORY CASELET

According to the third expert’s testimony, they would have eval-

uated the firm using a bottom-line cash flow strategy that took
normalisation adjustments into account, similar to what I per-
formed in my analysis. When questioned if they would have used
the “mean” revenue multiple, they said that they would only have
done so if the bottom-line cash flow for the transactions under
consideration was close to the “mean” of the data set. The judge
accepted the conclusions in my appraisal assessment.

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56 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

> Explain the meaning of valuation
> Recognise an understanding of enterprise value and equity
value
> Express Present Value and Net Present Value
> Describe the Internal Rate of Return (IRR) and Loan Tables
> Discuss Flat Payment Schedules
> Summarise Future Values and Applications

2.1 INTRODUCTION
Quick Revision In the previous chapter, you studied the financial modelling. Build-
ing spreadsheet models to quantitatively depict a company’s expected

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financial outcomes is known as financial modelling. The act of creat-
ing a financial representation of all or partial features of a company or
specific securities is known as financial modelling. The model is often
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known for doing computations and giving advice based on such data.

A company valuation provides management with information on

a variety of facts and numbers pertaining to the organisation’s true
worth or value in terms of market competition, asset values and rev-
enue values. Some of the salient advantages and benefits of business
valuation are a significant insight into the company assets, fathoming
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of the organisation’s resale value, in-depth knowledge during mergers

and acquisitions; getting a real company value and access to a range
of investors.
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Values have taken on a more prominent role as a result of the rise in

commercial activity. It doesn’t matter if it’s a multinational corporation
or a start-up company organisation; appraisals are common. Valuation
is regarded as a crucial factor for many related business operations,
from the establishment or genesis of the company entity to its mergers
and acquisitions, for receiving long-term financial help from banks or
financial institutions, winding up the organisation.

International Valuation Standards, Guidance to Valuation, Methods

employed in Valuation, Valuation of Tangibles and Intangibles, Valua-
tion during Mergers and Acquisitions, etc. are just a few of the many
important aspects of valuation. A professional must have a thorough
understanding of the aforementioned valuation-related topics in order
to approach valuation from all angles and resolve valuation-related
issues. Simply knowing the subject theoretically won’t cut it because
valuation isn’t an applied field of study where every component has a
practical application. Additionally, multiple valuation methodologies
should be utilised based on the size, scope and nature of the organi-
sation.
 CORPORATE VALUATION 57

In this chapter, you will get to know the meaning of and importance of
valuation. You will also get an understanding of enterprise value and
equity value along with present value and net present value. Further
on, you will be apprised of the Internal Rate of Return (IRR) and Loan
Tables, Multiple Internal Rates of Return and flat payment schedules.
The chapter will shed light on future values and applications. In the
end, you will gain knowledge about pension problems and continuous
compounding.

2.2 MEANING OF VALUATION

Valuation has gained significant recognition in business parlance.
Valuation has taken centre stage with the growth of various business NOTE
organisation forms, particularly the company form of business organ-
Tax reporting requires Valuation
isation and various activities revolve around it. As a result, valuation as well. The Internal Revenue
has become ubiquitous, whether during the beginning of an entity, Service (IRS) mandates that a
expansion, merger and acquisition or winding-up. company be valued at its fair

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Although valuation is sometimes thought of as a science, the factors in
value sometimes need natural subjectivity. In another sense, valuation
is not a precise science since it may be fraught with market imperfec-
market value. Some tax-related
events, such as the sale,
purchase, or gifting of remaining
stock, will be taxed based on
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Valuation.
tions. Company valuers nowadays should possess erudite knowledge
to ensure that business valuation theory and processes are well pre-
sented and understood. Therefore, business valuation has to be more
of a science than an exercise in perception and guesswork.

Even in the exceptional case where the appraiser has a complete

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understanding of the market, the market may not provide an accu-

rate understanding of worth as well as the technique and process of
assessment. There may not always be a clear-cut valuation approach
or a clear-cut value conclusion, but every valuation depends only on
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its own conditions. A rational, methodical approach and careful appli-

cation of the fundamental concepts are required for correct appraisal.
This implies that there might not be a set structure or preferred
approach that can be used in every situation.

A business valuation is a technique for determining the overall eco-

nomic importance of a company or other business entity. Business val-
uation can be utilised to fathom a company’s fair value for a myriad
of reasons, including sale value, partner ownership, taxation and even
settlement. Business owners quite frequently seek objective estimates
of the value of their businesses from professional business evaluators.

A business valuation typically entails scrutinising the top business,

capital structure, future income prospects or asset market value. Eval-
uators, businesses and industries all harness various tools for valua-
tion. The various tools may be a review of financial data, discounting
cash flow models, company comparisons, etc.
 Study
Hint
The accounting valuation of
the company’s assets less
all claims senior to common
equity (such as the company’s
liabilities) is known as book
value. The term “book value”
comes from the accounting
practice of recording asset
value in the books at the
original historical cost.
NOTE
Enterprise Value (EV) exhibits the
value of an organisation’s overall
operations to all stakeholders,
encompassing common
shareholders, preferred equity
holders and lenders of debt
financing.
60 FINANCIAL MODELLING

as enterprise value and the latter is known as Equity Value. Custom-

ers and investors frequently misunderstand how enterprise value and
stock value differ from one another. It is important to define every-
thing to compare company and stock values to help one make well-in-
formed investment decisions.

The enterprise value of a company is inferred as the entire financial

NOTE worth of all of the assets of the company, even entailing cash. The
Enterprise Value demonstrates enterprise value exhibits the worth of an organisation if it is to be
the value of the cardinal
operations of an organisation acquired by another company in the current market. Due to the fact
irrespective of how it raises that a company’s capital structure has no bearing on its overall worth,
finance and thus offers a precise enterprise value is a useful tool for investors and other organisations
comparison between companies
to discern between businesses with various capital structures.
owing to being independent of
their different capital structures.
A business expands and goes through several processes, one of which
can be mergers and acquisitions. A company can commence a merger
with various companies to forge a new business entity or acquire a dif-

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ferent company to further grow. In both instances, the company takes
the enterprise value of the other company into consideration before
finalising the acquisition.
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Along with the target firm’s outstanding debt, the purchasing com-
pany also takes cash into account while making an acquisition. Enter-
prise value is a crucial consideration for both organisations because
debt also drives up acquisition costs while company cash lowers them.

The formula that can be used to evaluate the value of any stabilised
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asset or company is:

Company’s Value = Cash Flow/(Discount Rate – Cash Flow Growth

Rate), where Cash Flow Growth Rate < Discount Rate.
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Equity value is defined as the total value of the company’s share and all
loans provided to the company by the company’s shareholders. This
is the value that remains for the benefit of the company’s sharehold-
ers after all debts have been settled. Investors must consider equity
value when assessing a company and its shares. This enables them
to understand the worth of your business both now and in the future.

The essence behind equity value is to determine how much the value
of a company affects its stock. Investors evaluate the company’s offer-
ings and its equity model. In the equity value calculation, enterprise
value is added to non-operating assets, then liabilities are subtracted
from available cash. However, the total value of shares can be better
understood by considering the number of shares outstanding (both
common and preferred) and the sum of borrowings from sharehold-
ers. Stock prices are volatile and may rise or decline based on our
share price in the stock market.
 CORPORATE VALUATION 61

The formula to calculate the equity value of a company:

Equity Value = Enterprise Value – (Total Debt + Cash)
Or
Equity Value = Number of Shares × Share Price

When we draw a comparison between enterprise value and equity

value, we will get an understanding that the enterprise value is used
more pervasively than the equity value. It is so because the enterprise
value enables analysts to ameliorate the capital structure from the val-
uation process. Nonetheless, enterprise value is cardinally utilised by
investment banks who seek to find the value of the entire organisation
before advising their clients on the merger or acquisition process.

Though analysts prefer recoursing to the enterprise value technique

more than the equity value, it is still an essential technique used in
equity research by investors. As investors seek to buy individual shares

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of the company and not the whole business, they harness equity value
and its current company value and foresee its future value by relying
on whether the share price has the potential to offer a good return.
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The enterprise value exhibits how much finance an organisation will
get if it was to sell the entire stakes to anyone in the market. It is a
crucial measure for companies that are underway to finalise the pro-
Study
cess of mergers and acquisitions. Through the use of enterprise value,
Hint
companies assure that they do not overspend more than what the
acquiree company is valued at. Equity value underscores
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an organisation’s worth by
On the contrary, equity value is a part of enterprise value that relates computing shareholder’s
equity. In other way, it is
to the equity aspect of the company and showcases how much value the total price at par to all
the company can generate if one is to purchase the shares of the com- shareholders’ equity.
pany.
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SELF ASSESSMENT QUESTIONS

2. Equity value can be computed by multiplying

a. Share price and number of authorised shares
b. Share price and number of subscribed shares
c. Share price and number of outstanding shares
d. Share price and number of unsubscribed shares
3. The _____________ exhibits how much finance an organisation
will get if it was to sell the entire stakes to anyone in the
market.
a. Market value b. Book value
c. Enterprise value d. Realisable value
62 FINANCIAL MODELLING

ACTIVITY

Get in touch with a budding entrepreneur and identify the business

firm’s enterprise value.

PRESENT VALUE AND NET PRESENT

2.4
VALUE
One of the key tasks of financial analysis is determining the monetary
value of assets. In part, this value is determined by the income gener-
ated during the life of the asset. Funds may be paid, making it difficult
to compare the value of different assets at another time. Lets’ start
NOTE with a simple case. Would you rather have assets to pay back `1,000
By making use of present value today, or is he the one who paid him `1,000 in a year? I found out that
one can swiftly assess the value
of an investment today. Utilising
the money was paid today Better than the money paid in the future.
Excel, investors can obtain a
prelude to of whether investing
money today on a certain asset
is worthy considering a specific
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This idea is called time Value for money. The time value of money is
at the heart of many financial Calculations, especially value-related.
If you had the choice of `1,000 or `1,100 a year from now? The second
option will pay you more (which is a good thing), but it pays off in the
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rate of return.
future (which is bad).

The present value is the existing value that one or more assets or
investments would have in the future discounted at the market rate.
The present value of future cash flows will always be less than the
same amount of future cash flows because cash received today can be
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invested for a higher return than cash promised in the future.

An essential aspect of the present value calculation is the interest rate

used for discounting. The market rate is the theoretically correct rate,
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but it can also be adjusted up or down to reflect the perceived risk of

the underlying cash flows. For example, if cash flow is considered very
problematic, a higher discount rate may be justified, reducing present
value.

Numerous financial decisions, including how to value pension liabili-

ties, whether to invest in fixed assets, and which sort of investment to
choose all depend on the idea of present value. In the latter scenario,
present value provides a standard foundation for differentiating dis-
tinct investment kinds. In hyperinflationary economies, when future
cash flows look to be worthless and become zero due to the rapid
decline in the value of money, the concept of present value is partic-
ularly crucial. This effect is made clearer by the use of current value.

Net Present Value (NPV) is the product of the difference between an

investment and the future cash flows from that investment over some
time. This allows companies and investors to decide whether to invest
based on the present value of future returns.
NOTE
NPV is a sort of valuation and
is pervasively utilised across
finance and accounting for
identifying the value of a
business, investment security,
capital project, new venture,
cost reduction program and
whatever entailing cash flow.
NOTE
Market value can differ radically
over a certain period of time
and is largely influenced by the
business cycle. Market values
are categorised under bear
markets that precede recessions
and augment during up-trends
that precede economic
expansion packs.
 Study
Hint
A company’s market value
may vary markedly from its
book value or shareholders’
equity. A stock is commonly
considered undervalued if its
value is significantly lower
than its book value, implying
that the stock trades at a
significant discount to book
value per share

NOTE
A positive IRR infers that
a project or investment is
anticipated to return value to the
company, while a negative IRR,
points out to a more intricate
cash flow stream that may make
the metric less useful.
 Study
Hint
Multiple internal rates of return
occurs when there is more
than one rate of return from
the same project/investment
that makes the net present
value of the project equal to
nil. This situation occurs when
the IRR method is utilised for
a project/investment in which
negative cash flows follow
positive cash flows.
 CORPORATE VALUATION 67

also known as non-normal cash flows, are cash flows with intermittent
streams of net cash inflows and outflows, i.e., net cash outflows may
occur at the start of the project, followed by net cash inflows and then
net cash outflows may occur afterwards.

At times a series of cash flows have more than one IRR. In the next
example we can tell that the cash flows in cells B6:B11 have two IRRs
since the NPV graph crosses the x-axis twice as shown in Figure 2.1:

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Figure 2.1: Calculating Multiple Interest Rate of Return

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Excel’s IRR function empowers us to add an extra argument which

will enable one to compute both IRRs. Rather than writing = IRR
(B6:B11), we will state = IRR(B6:B11,guess) . The argument guess is
a beginning point for the algorithm which Excel uses to calculate the
IRR, by adjusting the guess, we can evaluate both the IRRs.

SELF ASSESSMENT QUESTIONS

8. If the IRR is higher than the hurdle rate, the project is deemed
to be ___________.
a. Rejected
b. Accepted
c. Cannot be determined
d. May be accepted or rejected
68 FINANCIAL MODELLING

ACTIVITY

Find out the instance in which multiple IRRs may occur.

2.7 FLAT PAYMENT SCHEDULES

Several loans are paid back by utilising a series of payments over a
certain period. These payments generally entail an interest amount
computed on the outstanding balance along with the loan plus a por-
tion of the unpaid balance of the loan. This payment of a portion of the
unpaid balance of the loan is called the payment of principal.

There are usually two sorts of loan repayment schedules – even prin-
cipal payments and even total payments.

Furthermore, flat interest rate mortgages and loans calculate interest

based on the amount of money a borrower receives at the beginning

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of a loan. For example, You take out a loan for 10,000 at a 7% annual
interest rate. The commercial bank wants to make a series of pay-
ments over a ten-year period to pay off the loan and interest. Figure
IM
2.2 shows how we may calculate the required amount for each annual
payment using Excel’s PMT function:
M
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Figure 2.2: Flat Payment Schedules

Source: [Link]
tion-schedule-excel/

Notice that we have put “PV”—Excel’s nomenclature for the starting

loan principal—with a minus sign. As discussed above, if we do not do
this, Excel turns out to be a negative payment (a minor irritant).
 CORPORATE VALUATION 69

Figure 2.3 showcases creating a loan table:

S
Figure 2.3: Creating a Flat Loan Table

The zero in cell C15 points out that the loan is fully repaid over its
term of 6 years. One can easily state that the present value of the pay-
IM
ments over the 6 years is the initial principal of `10,000.

SELF ASSESSMENT QUESTIONS

9. Which of the following payment is a portion of the unpaid

balance of the loan?
M

a. Payment penance b. Payment of price

c. Payment of loan d. Payment of principal
N

ACTIVITY

Using excel find out flat repayment for a loan of `20,000 at an inter-
est rate of 7% per year.

2.8 FUTURE VALUES AND APPLICATIONS

Future value is the amount of money that a starting investment will
turn out to be, over time, at a certain compounded rate of interest. NOTE
For instance, an investment of `2,000 today in an account paying 4 % One can compute the future
interest will be worth `2,433.31 in five years. That’s an example of the value through compound interest
time value of money. using this formula: future value
= present value x (1 + interest
Future Value (FV) is the prevailing value of an asset at a future date rate)n
based on its assumed growth rate. Future value is cardinal to investors
and financial planners. As one can anticipate that the investment one
can do today will be worth it in the future. By estimating future value
investors can make informed investment decisions based on their
70 FINANCIAL MODELLING

anticipated needs. However, external economic factors, such as infla-

tion can affect the future value of assets by undermining their value.

Computing future value empowers investors to foretell the amount of

NOTE profit to be reaped from different investments with a varying magni-
To assess future value with tude of accuracy. The growth attained by holding a fixed amount of
simple interest, the formula is: cash may differ from investing the same amount in stocks. Thus, the
future value = present value x [1 future value equation is used to compare multiple options.
+ (interest rate x time)].
Evaluating the future value of an asset can be complex depending
on the type of asset. Future value calculations are also based on the
assumption of a continuous growth rate. When we put our money in
a savings account with guaranteed interest, it is simple to accurately
determine its future value. However, investing in the stock market or
other securities with more volatile returns can pose higher challenges.

Small business owners may overlook the time value of money as one
of those monotonous concepts, but it’s not as dull as it appears. Future

S
value and present value are key financial concepts that managers
make use of for day-to-day functioning, whether they know about it or
not. The money one possesses presently is worth more than the money
one will receive in a few years. The difference is the impact of inflation
IM
and the risk of not getting the money you expect in the future.

Suppose Raj deposit `1,000 in an account today, leaving it there for

10 years. Suppose the account draws an annual interest of 10%. How
much will you have at the end of 10 years? The answer is depicted in
the subsequent Figure 2.4:
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Figure 2.4: Simple Future Value

 CORPORATE VALUATION 71

As cell C17 showcases, we do not require all these intricate calcula-

tions: The future value of ` 1,000 in 10 years at 10% per year is given
by:

FV = 1,000 × (1+10%)10 = 2,593.74

Now let’s suppose the following, slightly more intricate, problem:

Again, one can tend to open a savings account. The starting deposit
of 1,000 today will be followed by a similar deposit at the beginning
of years 1, 2, ... , 9. If the account reaps interest of 10% per year, how
much as an investor one will have in the account at the beginning
of year 10? This problem is can be solved in Excel, as depicted in
Figure 2.5:

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M
N

Figure 2.5: Future Value in Annual Deposit

We can deduce that we will have 17,531.17 in the account at the culmi-
nation of year 10.

This similar answer can be exhibited as a formula that sums the future
values of each deposit:

Total at beginning of year 10 = 1,000×(1+10%)10 + 1,000×(1+10%)9+

.....+ 1,000×(1+10%)1
10
= ∑ 1,000×(1+10%)
t=1
(1 + 10%) t
72 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

10. __________ is the prevailing value of an asset at a future date

based on its assumed growth rate.
a. Market value
b. Book value
c. Present value
d. Future value

ACTIVITY

Compute the future value of `15,000 for 8 years with draws the
annual interest of 10%.

2.9
S
A PENSION PROBLEM—COMPLICATING
THE FUTURE VALUE PROBLEM
The Indian pension system has been replete with myriad problems.
IM
The gradual collapse of the ongoing pension system population high-
lights the need to strengthen formal pension channels. The immediate
and more pressing reasons for pension reform are also well known.
Informal employment is on the rise, while prevailing benefit systems
are distorted in favour of organised workers, and the biased treatment
of workers in the private sector and those in public institutions. The
M

need to boost domestic savings rates through the labour sector, an

underdeveloped private pension market and ultimately, higher con-
tract savings.
N

Supposedly Raja is 58 years old and would retire at age 60. To make
his retirement secure and comfortable, he postulates to start a retire-
ment account:

At the beginning of each of years 1, 2, 3, 4 (from today onwards and at

the start of each of the following four years), Raja intends to deposit
into the retirement account. Raja seeks to earn 8% interest per year.
Following retirement at age 60, for instance, Raja will live around 8
more years. At the onset of each of these years, Raja seeks to draw
`30,000 from his retirement account. Raja estimates that the account
balances will continue to earn 8%.

So based on the estimation how much should a deposit be made annu-

ally? The following figure bifurcates how easily Raja can go wrong
in this kind of problem—in this case, Raja calculated that to provide
`30,000 per year for 8 years, Raja requires to invest `2,40,000/5 =
`48,000 in each of the first 5 years. As the figure showcases, he will
end up with a significant amount of money at the end of 8 years.
 CORPORATE VALUATION 73

The problem is shown in Figure 2.6:

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Figure 2.6: Retirement Problem

There are varied ways to solve this problem. One such resolution
is through Excel Solver which can be located in the Data menu, as
shown in Figure 2.7:
M
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Figure 2.7: Excel Solver

74 FINANCIAL MODELLING

When we click on the solve box, we get the following result as shown
in Figure 2.8:

S Figure 2.8: Retirement Problem

IM
SELF ASSESSMENT QUESTIONS

11. The need to boost ____________ through the labour sector,

an underdeveloped private pension market and ultimately,
higher contract savings.
M

a. International savings rate

b. Domestic savings rate
c. Currency rate
N

d. Domestic recession

ACTIVITY

Find out in-depth about the pension problem using excel.

2.10 CONTINUOUS COMPOUNDING

When compound interest is calculated and reinvested into an account’s
balance across an essentially infinite number of periods, it is said to be
compounding continuously. While this is infeasible in virtue, the con-
cept of continuously compounded interest is crucial in the financial
aspect. Continuous compounding can be inferred as an extreme case
of compounding, as most interest is calculated on a monthly, quarterly
or semi-annual basis.
 `
`
` `
 `
`

r In

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 CORPORATE VALUATION 79

4. Which of the following shows the value of a current asset in a

future period based on an assumed rate of growth?
a. Future value
b. Present value
c. Time value
d. Coerce value
5. The Net Present Value (NPV) of a project is equal to the sum of
the ___________ of all the cash flows.
a. Present values
b. Future values
c. Time value
d. Expected value
6. A _____________ provides the management of the company with

true worth or value.

a. Business vehemence S
several information and numbers pertaining to the organisation’s
IM
b. Business audit
c. Business virtue
d. Business valuation
7. The focal point of the corporate type of business organisation has
M

been __________, around which many operations are conducted.

a. Caricature
b. Valuation
N

c. Vernacular
d. Veracity
8. Expand the term IRR.
a. Internal Rate of Return
b. Invested Rate of Return
c. Internal Rate of Repugnance
d. Internal Ratio of Return
9. The ______________of a company is inferred as the entire financial
worth of all of the assets of the company, even entailing cash.
a. Erudite value
b. Evanescence value
c. Enterprise value
d. Internal value
80 FINANCIAL MODELLING

10. ____________ is defined as the total value of the company’s

share and all loans provided to the company by the company’s
shareholders.
a. Market value b. Stock value
c. Deemed value d. Equity value

2.13 DESCRIPTIVE QUESTIONS

? 1. State the meaning of valuation.
2. Explain the importance of valuation.
3. Discuss enterprise value.
4. Describe equity value.

HIGHER ORDER THINKING SKILLS

2.14
(HOTS) QUESTIONS
S
1. If you deposit `1000 today in a bank which pays 10% interest
compounded annually, then how much will the deposit grow to
after 8 years?
IM
a. `20,100 b. `8.044
c. `1,142 d. `2,144
2. Suppose Golu is an investor who invests in bank security.
Golu disburses `1,00,000 and later on sells it for `1,08,000 after
M

a year. Find out the annual rate of return on the security on a

continuously compounded basis.
a. 7.7% b. 8.7%
c. 10.6% d. 11.1%
N

2.15 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Meaning of Valuation 1. a. Low-cost
Understanding enterprise value 2. c. Share price and num-
and equity value ber of outstanding
shares
3. c. Enterprise value
Present Value and Net Present 4. a. NPV
Value
5. c. Positive
The Internal Rate of Return (IRR) 6. b. IRR
and Loan Tables
 CORPORATE VALUATION 81

Topic Q. No. Answer

7. d. Estimated expenditure
Multiple Internal Rates of Return 8. b. Accepted
Flat Payment Schedules 9. d. Payment of principal
Future Values and Applications 10. d. Future value
A Pension Problem—Complicat- 11. b. Domestic savings rate
ing the Future Value Problem
Continuous Compounding 12. b. Continuous com-
pounding

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. c. Time value of money
2. a. Number of compounding periods per year
3.
4.
5.
b.
a.
a.
Present value
Future value
Present value S
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6. d. Business valuation
7. b. Valuation
8. a. Internal Rate of Return
9. c. Enterprise value
10. d. Equity value
M

ANSWERS FOR DESCRIPTIVE QUESTIONS

1. Valuation has gained significant recognition in business parlance.
The term “valuation” has become widely used in business.
N

Valuation has taken centre stage with the growth of various

business organisation forms, particularly the company form of
business organisation and various activities revolve around it.
Refer to Section 2.2 Meaning of Valuation
2. Valuation is useful for several business functions, such as
mergers and acquisitions, sale of a business, procurement of
funds and taxation. Unless and until the important managerial
personnel are well knowledgeable about the valuation processes
involved in the aforementioned business events, it will be highly
intricate for them to fulfil their professional commitments. Refer
to Section 2.2 Meaning of Valuation
3. The enterprise value of a company is inferred as the entire
financial worth of all of the assets of the company, even entailing
cash. The enterprise value exhibits the worth of an organisation
if it is to be acquired by another company in the current market.
Refer to Section 2.3 Understanding Enterprise Value and
Equity Value
`

` ` `

Practical financial modelling

Principles of financial modelling

 C H A
3 P T E R

COMPARABLE COMPANY ANALYSIS

CONTENTS

3.1 Introduction
3.2
3.2.1
3.2.2 S
Introduction to Comparable Company Analysis
Selecting Comparable Companies
Spreading Comparable Companies
IM
3.2.3 Analysing the Valuation Multiples
3.2.4 Concluding and Understanding Value
Self Assessment Questions
Activity
3.3 Introduction to Precedent Transactions Analysis
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3.3.1 Selecting Comparable Transactions

3.3.2 Spreading Comparable Transactions
3.3.3 Concluding Value
Self Assessment Questions
N

Activity
3.4 Four Methods to Compute Enterprise Value (EV)
Self Assessment Questions
Activity
3.5 Using Accounting Book Values to Value a Company
Self Assessment Questions
Activity
3.6 The Firm’s Accounting Enterprise Value
Self Assessment Questions
Activity
3.7 The Efficient Markets Approach to Corporate Valuation
Self Assessment Questions
Activity
3.8 Enterprise Value (EV) as the Present Value of the Free Cash Flows
Self Assessment Questions
Activity
84 FINANCIAL MODELLING

CONTENTS

3.9 Summary
3.10 Multiple Choice Questions
3.11 Descriptive Questions
3.12 Higher Order Thinking Skills (HOTS) Questions
3.13 Answers and Hints
3.14 Suggested Readings & References

S
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 COMPARABLE COMPANY ANALYSIS 85

INTRODUCTORY CASELET

COMPARABLE COMPANY ANALYSIS

Every professional banker begins their career by learning the dif-

ferent processes in the context of how to conduct a corporation’s Case Objective
analysis, also known as a comparable company analysis. An exam- This caselet discusses the
ination of comparable companies can be made in a pretty simple concept of Comparable
manner. The data in the report is used to arrive at an approxima- Company Analysis (CCA).
tion of the value of the company or the stock price.

Comparable company research is predicated on the idea that

similar businesses offer a useful point of comparison from which
to calculate an estimated valuation of the target business. The
inferred valuation derived from Trade Company is not intended
to be an exact measurement, rather, it is used to establish criteria
for the target firm based on the current market pricing of compa-
rable businesses.

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Source:[Link]
sis-comps/
IM
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86 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

> Define the introduction to Comparable Company Analysis
(CCA)
> Explain the introduction to precedent transactions analysis
> Discuss the four methods to compute enterprise value
> Describe using accounting book values to value a company
> Classify the firm’s accounting enterprise value
> Clarify the efficient markets approach to corporate valuation
> Summarise the Enterprise Value (EV) as the Present Value
(PV)

3.1 INTRODUCTION
Quick Revision
S
In the previous chapter, you studied the corporate valuation. A com-
pany valuation provides management with information on a variety
of facts and numbers pertaining to the organisation’s true worth or
IM
value in terms of market competition, asset values and revenue val-
ues. Some of the salient advantages and benefits of business valua-
tion are a significant insight into the company assets, fathoming of
the organisation’s resale value, in-depth knowledge during mergers
and acquisitions; getting a real company value and access to a range
of investors.
M

Professionals such as financial analysts and many others perform cer-

tain activities to make certain analyses of the business corporation.
This analysis is a step-by-step approach and is usually done to finalise
the financial position of the economic entity and through which cer-
N

tain decisions can be taken.

The main agenda of the analysis is to provide satisfaction to different

stakeholders that the values occurring in the financials of the organi-
sation are true and fair and to know about the level of performance as
compared to earlier years of the business.

The choice of similar companies affects the trading comps study’s

accuracy. The trade comps valuation will often be more accurate the
stricter the screening procedure for comparable companies is.

The Comparable Company Analysis (CCA) is predicated on the idea

that businesses with comparable size, sector and stature will be eval-
uated similarly. The important thing to remember is that while this
method will provide an estimate that is close to the value, the valu-
ation in other circumstances may be very different from the actual
worth.
NOTE
Professionals perform
Comparable Company Analysis
to measure the performance of
the corporation.

NOTE
Process of Comparable
Company Analysis is a step-by-
step approach.
 TURN TO THE
WEB
Study and find out about the
criteria followed by today’s
corporations while choosing
comparable companies.
NOTE
Financial ratios play important
role in the process of
Comparable Company Analysis.
 COMPARABLE COMPANY ANALYSIS 91

ACTIVITY

Find out the main objective of Comparable Company Analysis.

INTRODUCTION TO PRECEDENT
3.3 NOTE
TRANSACTIONS ANALYSIS
The understanding of the
Using specific financial data from previous Merger and Acquisition difference between merger
(M&A) deals and transactions, precedent transaction analysis is a and acquisition concepts is
technique for valuing businesses. mandatory for the precedent
transaction analysis.
This approach of valuation, often known as “precedents,” is fre-
quently created by analysts working in investment banking, private
equity and corporate development when attempting to value a whole
organisation as part of a merger or acquisition.

S
To provide a credible approximation of the multiples or premiums
that others have paid for a publicly traded company, precedent trans-
action analysis uses information that is readily accessible to the gen-
IM
eral public.

The analysis assesses whether the corporations making the purchases

are likely to make another acquisition soon and looks at the types of
investors who have previously bought comparable companies under
comparable circumstances.
M

3.3.1 SELECTING COMPARABLE TRANSACTIONS

The first step in the procedure is to hunt for similar transactions that
have taken place in the recent (preferably) past and are in the same
N

sector.

These kinds of standards must be established for the screening proce-

dure. An analyst must “clean” the transactions by carefully analysing
the business descriptions of the organisations on the list and deleting
any that aren’t a close enough fit before sorting and filtering them.

If the deal conditions weren’t made public, many transactions would

have missing or incomplete information. A press release, equity
research study or other sources that include deal metrics will be
sought after diligently by the analyst. If nothing is discovered, those
businesses will be crossed off the list.

The average, or chosen range, of valuation multiples, can be deter-

mined once a shortlist has been created (by doing processes 1 and 2).
EV/EBITDA and EV/Revenue are the most often used multiples for
antecedent transaction analysis.
NOTE
Step-by-step process is followed
in the case of spreading
comparable transactions.
NOTE
Enterprise value calculation is
important because it attracts the
investors for the investment in
the case where value is good in
terms of financial position.
94 FINANCIAL MODELLING

of both its tangible and intangible assets using the valuation

process known as brand valuation.
The projected worth of a brand derived from this valuation
process is based on factors such as customer perception, financial
performance, brand equity and comparable measures. The
worth of your brand determines your company’s market value.
Therefore, in the event of mergers and acquisitions, firms need
brand appraisals.
The return on brand investment for the company is determined
by brand valuation. For the creation of upcoming strategies, this
information is essential. Budget allocation decision-making is
aided by brand valuation.
2. Income Approach: One of the three primary strategies for valuing
a corporation is the income approach. By examining factors
including revenue, taxes and expenses, the income approach to

S
valuation determines the present value of future income that a
corporation will earn.
The income method of valuation is founded on the idea that a
IM
potential investor wants to know the financial returns on their
investment. The income method to business valuation evaluates
both the potential returns on investment and the associated
risks.
The income approach to business valuation uses a formula to
estimate future revenues, operational income, costs, net profit
M

and the amount of cash the company will eventually be able to

generate.
The discounted cash flow method, the price earning capacity
method, and the option pricing method are the three different
N

valuation approaches that fall under the umbrella of the income

approach to business valuation.
TURN TO THE 3. Market Approach: One of the most popular techniques for a
WEB business appraisal is the market approach.
Study and find out about the
easiest method for calculating This valuation method, as the name implies, estimates the worth
the EV. of the subject business, its intangible assets, securities and
business ownership interest using pertinent financial data from
similar or identical companies.
Using this approach of valuation, the size and activities of a
comparable business are compared to determine the worth of
the subject business.
This valuation technique determines appraisal value using
price-related factors such as sales. The relative value approach
is another name for this method of valuation.
The Market Price Method, Comparable Companies Method,
Comparable Transaction Method and EV to Revenue Multiples
 COMPARABLE COMPANY ANALYSIS 95

Method are the four different approaches that make up the

market approach to business valuation.
4. Cost Method: One of the popular methods of valuation is termed
a cost method. This method is based only on a single assumption.
The same assumption is that a particular buyer will not give or
pay more than the cost of the property in the case where the cost
of that particular property is almost equal to the cost incurred in
developing the same property.
When determining the value of a firm, the cost approach to
valuation estimates the values of the tangible and intangible
assets and liabilities that make up the business.
The cost approach to valuation is a practical method for established
businesses with substantial assets, holding corporations and
asset-intensive businesses even though it is not widely regarded
as a reliable indicator of the business value. This approach to real
estate valuation is suitable for valuing facilities with particular

S
uses, such as schools, hospitals and places of worship.
It is also the preferred method of value for assessing new
buildings, insurance appraisals and commercial real estate.
IM
SELF ASSESSMENT QUESTIONS

5. Which of these is not the method of calculating enterprise

value?
a. Cash approach b. Income approach
M

c. Market approach d. Expenditure approach

6. Examining factors including revenue, taxes and expenses is
an approach of the ___________ method.
N

a. Cash approach b. Income approach

c. Market approach d. Brand valuation method

ACTIVITY

Find out the easiest method for calculating the enterprise value.

USING ACCOUNTING BOOK VALUES TO

3.5
VALUE A COMPANY
Book value or accounting book value can be defined as the difference TURN TO THE
WEB
between all claims senior to common equity (such as the company’s
Search and find about the book
liabilities) and the accounting value of the company’s assets. The
value of stockholders’ equity for
accounting practice of documenting asset value at the original histori- Mahindra Company.
cal cost in the books is where the phrase “book value” originates.

Investors use a company’s book value to assess whether its shares are
overvalued or undervalued. The total of all line items included in the
 TURN TO THE
WEB
Research and study about the
difference between the common
stock and preferred stock.
NOTE
Cash and cash equivalents are
the most liquid for the asset and
hence get placed on the top of
the heading of current assets.

NOTE
Value of total assets is equal to
the sum of value of total debt
and value of total stockholders’
equity.
 TURN TO THE
WEB
Search and study about the
concepts of EMA (Efficient
Market Approach)
100 FINANCIAL MODELLING

ACTIVITY

Find out the disadvantages of using the Efficient Market Approach.

ENTERPRISE VALUE (EV) AS THE

3.8 PRESENT VALUE OF THE FREE CASH
FLOWS
Given a certain rate of return, Present Value (PV) is the current value
of a future financial asset or stream of cash flows. The discount rate
TURN TO THE
WEB determines how much future cash flows are discounted, and the
Search and study about the main higher the discount rate, the lower the present value of those future
difference between levered and cash flows will be.
unlevered firm or company.
To calculate the Enterprise Value (EV) of the company, the terminal
value predicted at the conclusion of the projection period and the

S
Unlevered Free Cash Flows (UFCFs) anticipated during the projec-
tion period are discounted to their present values using the chosen
discount rate. The timing assumptions for the cash flows within a pro-
jection interval have an impact on the calculation of EV. Mid-period
IM
convention assumes that the UFCFs occur amid each projection inter-
val, as opposed to the end-period convention, which assumes that the
UFCFs occur at the end of each interval. Because it is more conserva-
tive, the end-period convention is frequently adopted in practice (the
UFCFs are discounted at a time more distant from the present).
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In the EV calculation above, the end-period convention is taken for

granted. Based on the mid-year convention, the EV is calculated using
the following formula:
FCF1 FCF2 FCFn TV
EV = + + .... + +
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0.5 1.5 n − 0.5

(1 + r) (1 + r) (1 + r) (1 + r) n
EV-= Enterprise value
NOTE FCF= Future Cash Flows
Weighted Average Cost of
Capital is an important concept TV= Terminal Value
used in the calculation of EV.
r= WACC (Weighted Average Cost of Capital)

The following formula is used to compute the EV based on the mid-

year convention:
FCF1 FCF2 FCFn TV
EV = 0.5
+ 1.5
+ .... + n − 0.5
+
(1 + r) (1 + r) (1 + r) (1 + r) n
To advance the current value of UFCFs using the end-period conven-
tion by half a year, multiply it by (1+r)0.5 as follows:

EV (mid-period convention) =
TV
) × (1 + r)0.5 +
nvention×
PV of UFCFs (end-period convention)
(1 + r) n
S
 COMPARABLE COMPANY ANALYSIS 103

3. When combined, the intrinsic and relative valuation models offer

a rough estimate of value that analysts can use to determine the
true value of a ___________.
a. Shares b. Debt
c. Company d. Current liabilities
4. Which of the following multiples cannot be used in CCA?
a. Enterprise value to sales ratio
b. Enterprise value to EBIT ratio
c. Price to earnings ratio
d. Employee retention ratio
5. EMA stands for
a. Efficient Market Approach
b. Elegant Market Approach
c. Efficient Manager Approach
d. Emerged Market Approach S
IM
6. Using specific financial data from previous merger and
acquisition deals and transactions, __________ is a technique for
valuing businesses.
a. Comparable companies analysis
b. Companies comparable analysis
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c. Comparable cost analysis

d. Precedent transaction analysis
7. The process of calculating a business’s financial value is known
N

as business valuation or computation of __________.

a. Share value b. Bonds value
c. Enterprise value d. Asset value
8. The process of determining a brand’s value or how much
someone is prepared to pay for it is referred to as___________.
a. Brand valuation approach
b. Income approach
c. Market approach
d. Cash approach
9. The book value per share is calculated by dividing book value by
the total number of outstanding _________.
a. Market value b. Net realisable value
c. Shares d. Acquisition value
104 FINANCIAL MODELLING

10. Short-term investments, marketable securities, commercial

paper and money market funds are a few examples of __________.
a. Enterprise value b. Cash equivalents
c. Book value d. Acquisition value

3.11 DESCRIPTIVE QUESTIONS

? 1. Define the term CCA.
2. State the terminology of precedent transaction analysis.
3. Express the efficient market approach.
4. Define the book value.
5. Define the term present value.

HIGHER ORDER THINKING SKILLS

3.12
(HOTS) QUESTIONS
S
1. The company is _______ if the valuation ratio is lower than the
average for its peers.
IM
a. Overvalued
b. Undervalued
c. Can be overvalued or undervalued
d. Cannot be determined
2. Price to earnings ratio will decrease if
M

a. Price of the share will increase

b. Earnings will decrease
c. Earnings will increase
N

d. Price remains the same and earnings decrease

3. Analysts prefer to confirm cash flow valuation with relative
comparisons in addition to __________.
a. Market valuation b. Book valuation
c. Intrinsic valuation d. Shares valuation

3.13 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Introduction to Comparable 1. a. Comparable Companies
Company Analysis Analysis
2. d. Name of the Business
Introduction to Precedent 3. a. Business
Transactions Analysis
 COMPARABLE COMPANY ANALYSIS 105

Topic Q. No. Answer

4. a. Finding out the relevant
event or transactions
Four Methods to Compute 5. d. Expenditure approach
Enterprise Value (EV)
6. b. Income approach
Using Accounting Book Values 7. c. Interest expense
to Value a Company
8. b. Book value
The Firm’s Accounting Enter- 9. a. Preferred stock
prise Value
10. c. Enterprise value
The Efficient Markets Ap- 11. c. Stock price
proach to Corporate Valuation
12. b. Efficiently
Enterprise Value (EV) as the 13. d. Debt Value
Present Value of the Free Cash
Flows
14. b.

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Present Value
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ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. a. Company Comparable Analysis
2. b. Overvalued
3. c. Company
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4. d. Employee retention ratio

5. a. Efficient Market Approach
6. d. Precedent transaction analysis
7. c. Enterprise value
8. a. Brand valuation approach
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9. c. Shares
10. b. Cash equivalents

ANSWERS FOR DESCRIPTIVE QUESTIONS

1. Comparably by contrasting a firm’s valuation multiples with
those of its competitors, a relative valuation method known as
“Company Comparable Analysis” or “Comps” can be used to
determine the value of a specific business entity or any company.
Refer to Section 3.2 Introduction to Comparable Company
Analysis
2. Using specific financial data from previous merger and acquisition
(M&A) deals and transactions, precedent transaction analysis is
a technique for valuing businesses. This approach of valuation,
often known as “precedents,” is frequently created by analysts
working in investment banking, private equity and corporate
development when attempting to value a whole organisation as
 CASE STUDIES
1 TO 3

CONTENTS

Case Study 1 Comparing and Analysing Sales in NEVTRA

Case Study 2 Internal Rate of Return
Case Study 3 Enterprise Value (EV)

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108 FINANCIAL MODELLING

CASE STUDY 1

COMPARING AND ANALYSING SALES IN NEVTRA

COMPANY OVERVIEW
Case Objective
NEVTRA is a retail shop founded in 1990 by two friends, Yash
This case study discusses the
use of a chart for comparing
Vardhan and Vikas Rawat. The organisation started by selling
and analysing sales in only two computer hardware products, i.e., keyboard and mouse.
NEVTRA. As the business grew, NEVTRA started to sell various other com-
puter-related hardware and software products.

THEIR NEEDS

In NEVTRA, all purchase- and sales-related data of hardware and

software products were recorded manually in the register. Hence,
it was very time-consuming and tedious to calculate the total sales
of the different products in each quarter. To get an exact picture
of the growth rate of their business, the owners also wanted to

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compare last year’s sales of products with that of the current year.
Needless to say, the possibility of errors in such manual calcula-
tions remained always high. Hence, they decided to automate all
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their data-related processes and calculations and discussed their
problem with their friend Mehul who was also the IT head of a
company.

SOLUTION
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Mehul suggested they use the spreadsheet-based application to

store, analyse, manipulate and visualise their data in different
ways. With the guidance of Mehul, Yash and Vikas started to re-
cord all the purchase- and sales-related data of hardware and
software products in MS Excel. Now, they can easily calculate the
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total sales of their hardware and software products by using var-

ious types of formulas and functions. The following figures show
how they have recorded their quarter-wise sales of different prod-
ucts in the MS Excel worksheet:

MS Excel also allowed them to represent the result of their data

analysis in the form of charts. Yash used the Column chart to com-
 CASE STUDY 1: COMPARING AND ANALYSING SALES IN NEVTRA 109

CASE STUDY 1

pare the sales for the Year 2018 and Year 2019, as shown in the
following figure:

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QUESTIONS
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1. Why did the owners of NEVTRA decide to use the spread-

sheet application to record their business data?
(Hint: To calculate, compare and analyse the sales of dif-
ferent products)
2. Which feature of MS Excel enabled Yash to compare the
sales for Year 2018 and Year 2019?
(Hint: The chart feature of MS Excel application)
110 FINANCIAL MODELLING

CASE STUDY 2

INTERNAL RATE OF RETURN

Global Capitals, a financial institution, was in the business of

Case Objective lending money, short-term loans and share broking. In the cur-
This case study highlights rent year, the company decided to initiate an investment plan for
how a manager used IRR the members and other investors. The company finalised to pay
for solving an investment `2,01,475 at the end of 10 years with the deposit of `15,000 p.a.
problem.
The implicit rate calculated by the manager because it generates
the return on the investment. They made the following calcula-
tion chart for the same purpose:

Yearly Yearly sum Rate of

Investment (`) (with interest) Interest
Start of 1st year 15,000 15,000.00
End of 1st year 15,000 30,795.04 5.30%
End of 2nd year
End of 3rd year
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15,000
47,427.26
64,941.04
5.30%
5.30%
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End of 4th year 15,000 83,383.09 5.30%
End of 5th year 15,000 1,02,802.62 5.30%
End of 6th year 15,000 1,23,251.44 5.30%
End of 7th year 15,000 1,44,784.10 5.30%
End of 8th year 15,000 1,67,458.05 5.30%
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End of 9th year 15,000 1,91,333.79 5.30%

End of 10th year 0 2,01,475.00 5.30%
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In this way, the managers made use of the method of hit and trial
to achieve the expected outcome. And came out with the implicit
rate of return as 5.30%.

QUESTIONS

1. Identify the method of calculation used in the above case.

(Hint: The managers made use of the method of hit and
trial to achieve the expected outcome. It came out with
the implicit rate of return as 5.30%)
2. Discuss the merits and demerits of the IRR method.
(Hint: Merits: takes into the account time value of money,
and considers the cash flow stream in its entirety. Demer-
its: IRR may not be uniquely defined. It cannot distin-
guish between lending and borrowing)
 CASE STUDY 3: ENTERPRISE VALUE (EV) 111

CASE STUDY 3

ENTERPRISE VALUE (EV)

Mr. Tor Raj joined a global FICO score organisation following his
graduation from college school. After joining the association, he Case Objective
had an acceptance program on monetary detailing and budget re- This case study showcases
ports examination for 30 days. He was extremely curious to learn, enterprise value.
and he could overhaul his abilities in fiscal summaries examina-
tion about credit scores.

After finishing his enlistment, he was posted in corporate FICO

score. Then, at that point, he was requested to examine budget re-
ports from Alpha Company Limited and Beta Company Limited.
He required three days to gather the information and apply strat-
egies for budget reports investigation in these two organisations.
He also considered comparing the analysis of these two organisa-
tions with similar organisations under various financial scenarios.
Following three days, he arranged his power direct show toward

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a gathering of ranking directors for their remarks and endorse-
ment. The focal point of Mr. Tor’s examination depended on the
Balance Sheet, Income Statement and bookkeeping approaches
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embraced by the organisations. The show was not considered,
and it was unacceptable. The ranking directors felt that he ought
to likewise involve income proclamation for examination and re-
turn with a new show on the following day. Therefore, Mr. Tor
reviewed what he learned about Cash stream points in the book-
keeping class. He recollected that income proclamation is among
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the most valuable assertions for investigation alongside account-

ing reports and pay explanations. This assertion presents cash
in-streams and money out streams ordered under three classifi-
cations: money from working exercises, cash from putting away
exercises and money from supporting exercises.
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Cash from Operations addresses the money inflows and outpour-

ings produced out of centre business exercises of the association.
Cash deals and assortment from the clients are instances of mon-
ey inflows from tasks. Cash outpourings are connected with in-
stalments to representatives, sellers, charge specialists and oth-
ers expected for everyday activities are instances of money surges
from tasks.

Indian Accounting standard (Ind AS 7) permits the substance to

report the incomes from working exercises utilising either the im-
mediate. The organisation is allowed to choose a suitable tech-
nique.

Incomes from Investing exercises comprise money inflows and

outpourings connected with buy/offer of non-current resources
and non-current speculations XXXX. Instalments for acquiring
112 FINANCIAL MODELLING

CASE STUDY 3

property, plant and hardware and obtaining licenses are the in-
stances of money outpourings of financial planning exercises.

Assortment of money at a bargain of property, plant and gear and

different ventures are cash inflows of financial planning exercis-
es. At last, the net of these money inflows and surges address the
incomes from effective financial planning exercises.

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Incomes from Financing exercises comprise money inflows and

money outpourings connected with long haul and momentary
wellspring of funding. Issues of value shares, issues of bonds and
borrowings from banks are instances of money inflows of funding
exercises. Redemption of securities, reimbursement of borrow-
ings, instalment for share buyback and instalment of premium
on acquired capital and profit to value investors are the instances
of money outpourings of supporting exercises. The net of these
money inflows and surges addresses the incomes from financial
planning exercises.
 CASE STUDY 3: ENTERPRISE VALUE (EV) 113

CASE STUDY 3

Examination of income proclamation is a major test for Mr. Tor

since how he might interpret the instruments and procedures are
bound to the investigation of accounting reports and pay artic-
ulation. He was thinking about how to begin the examination of
income proclamations. He is considering some of the questions,
including why the income statement is different from the balance
sheet and the profit and loss statement, as well as how to inter-
pret something that is very similar. He was figuring out what ex-
tra investigation could be made given Cash stream proclamations
to prove his previous examination. The ranking director’s disap-
pointment is meandering in his mind.

QUESTIONS

1. What does cash from operations exhibit?

(Hint: Cash from Operations addresses the money inflows

cises of the association)

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and outpourings produced out of centre business exer-

2. What do all incomes from financing exercises entail?

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(Hint: Incomes from financing exercises comprise money
inflows and money outpourings connected with long haul
and momentary wellspring of funding. Issue of value
shares, issue of bonds and borrowings from banks are
instances of money inflows of funding exercises)
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 C H A
4 P T E R

DISCOUNTED CASH FLOW (DCF) ANALYSIS

CONTENTS

4.1 Introduction
4.2
4.2.1
4.2.2 S
Discounted Cash Flow (DCF) Analysis
Understanding Unlevered Free Cash Flow
Forecasting Free Cash Flow
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4.2.3 Forecasting Terminal Value
Self Assessment Questions
Activity
4.3 Present Value and Discounting
Self Assessment Questions
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Activity
4.4 Understanding Stub Periods
4.4.1 Analysis of bonds and swaps
Self Assessment Questions
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Activity
4.5 Performing Sensitivity Analysis
Self Assessment Questions
Activity
4.6 Cash Flows: DCF “Top Down” Valuation
Self Assessment Questions
Activity
4.7 Consolidated Statement of Cash Flows (CSCF)
Self Assessment Questions
Activity
4.8 Free Cash Flows Based on Consolidated Statement of Cash Flows (CSCF)
Self Assessment Questions
Activity
4.9 Free Cash Flows Based on Pro Forma Financial Statements
Self Assessment Questions
Activity
116 FINANCIAL MODELLING

CONTENTS

4.10 Summary
4.11 Multiple Choice Questions
4.12 Descriptive Questions
4.13 Higher Order Thinking Skills (HOTS) Questions
4.14 Answers and Hints
4.15 Suggested Readings & References

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 DISCOUNTED CASH FLOW (DCF) ANALYSIS 117

INTRODUCTORY CASELET

SENSITIVITY ANALYSIS

Suppose you are an owner of a restaurant and running that

restaurant for about 4 years. The restaurant business is quite con- Case Objective
sistent and there is no increase in business in the last 2 years. You This caselet aims to explain
decided to invest some of your time in analysing the business and the sensitivity analysis.
find out what can be done to maximise the sales in the next com-
ing months. You chose to perform sensitivity analysis.

Sensitivity analysis works based on what-if analysis. It finds out

how independent factors can influence or impact the dependent
factor. Sensitivity analysis helps in predicting the result or out-
come when performed under some specific conditions. Sensitiv-
ity analysis is commonly used by investors or organisation who
considers the conditions or factors which may affect their poten-
tial investment. This analysis helps in testing, predicting and eval-
uating the outcome.

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You decided to consider multiple areas of the restaurant which
you want to modify or change and made assumptions related to
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the outcome.

You have a list of changes you want to make in your restaurant,

such as a new menu, re-decoration, a new theme or new cousin
offering, additional catering, or an expansion of the dining area.

When you analysed each option closely, you realised that cost of
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changing is going very high. You understood the result and also got
to know what the cost of the change will be. Upon analysing each
of the options, you found that changing the theme and expanding
the dining room size will be costlier than justified based on the
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amount of revenue each option would bring.

However, few changes can be made immediately for the success

of the restaurant. These changes can be reviewed and menu can
be changed. You can make additions to the catering. With the help
of these changes, you can easily increase the revenue by 14 to 16
per cent in the next 5 or 6 months. The sensitivity analysis helps in
revealing what each of these options offers to increase your reve-
nue without increasing costs.
118 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

> Describe the Discounted Cash Flow (DCF) Analysis
> Summarise the Present Value (PV) and discounting
> Analyse the sensitivity analysis
> Define the DCF “Top Down” valuation
> Examine the consolidated statement of cash flows
> Discuss the cash flows Based on Consolidated Statement of
Cash Flows (CSCF)
> Elucidate the free cash flows based on pro forma financial
statements

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4.1 INTRODUCTION
In the previous unit, you studied comparable company analysis and
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Quick Revision
precedent transactions analysis. You also studied the four methods to
compute Enterprise Value (EV). The Efficient Markets Approach to
Corporate Valuation and Enterprise Value (EV) as the Present Value
of the free cash flows were also discussed.

For a reporting period, an entity’s cash flows from operating, investing

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and financing operations must be prepared and presented by the prin-

ciples and guidelines prescribed by Indian Accounting Standards 7.
The purpose of Indian Accounting Standards 7 is to give information
on an entity’s historical changes in cash and cash equivalents as a
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result of its operating, investing and financing activities throughout

the reporting period. Inflows and outflows of cash and cash equiva-
lents are known as cash flows.

Discounted Cash Flow (DCF) analysis refers to the method used to

value investment by discounting the estimated future cash flows. This
analysis is used for finding the value of a stock. DCF is applied to value
a company, a project and many other assets or activities. Therefore,
we can say that DCF analysis is widely used in both the investment
industry and corporate finance management.

One can calculate the value of return that an investment creates after
accounting for time value of money with the use of DCF analysis. This
analysis can be done for finding the value or worth of the projects or
investments that are expected to generate cash flows in future. It must
be noted that the DCF and initial investments are compared.
 NOTE
` DCF analysis can be based on
determining the estimated cash
` ` ` flows of an investment by using
a discounted rate.
120 FINANCIAL MODELLING

For instance, a company is investing in a project worth `10,000 at

a discount rate of 10% with the provided cash flows given as under
Table 4.1:

TABLE 4.1: CASH FLOWS GIVEN TO CALCULATE

PRESENT VALUES
Number of Years Amounts of Cash flows (`)
First 2,000
Second 3,000
Third 5,000
Fourth 3,000

Now, the present values are determined as under Table 4.2:

TABLE 4.2: CALCULATION OF PRESENT VALUES

Number
of Years S
Amounts
of Cash
flows
PV of `1 =

(1+discount
1
rate )
time period
Discounted Cash flows =
(cash flows × present value )
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First `2,000 1 `2,000×0.9090= `1,818
= 0.9090
(1 + 0.10) 1

Second `3,000 1 `3,000×0.8264= `2,479.20

=0.8264
(1 + 0.10) 2
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Third `5,000 1 `5,000×0.7513=`3,756.50

= 0.7513
(1 + 0.10) 3

Fourth `3,000 1 `3,000×0.6830=` 2,049

= 0.6830
(1 + 0.10)
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4.2.1 UNDERSTANDING UNLEVERED FREE CASH FLOW

Unlevered free cash flow is the value that an organisation has before
reimbursing its financial liabilities. It is a kind of amount being deter-
mined before including any interest charges. This is being reported
in the accounting statements of an organisation. It is an ideal concept
being applied at the time of doing DCF Analysis. It is considered to be
the amount available for making reimbursements to debt and equity
investors. This is not an ideal concept for identifying the leverage of
the organisation as it completely ignores the changes in capital struc-
ture over the period.

The formula for computing unlevered cash flow is given as under:

Income before interest, taxes, depreciation and amortisation – Capital

expenditures – Working capital
 MARK IT!
`
` Capital expenditures represent
the amount being spent on
` the acquisition of fixed assets.
` Working capital represents
the amount left after deducting
` short-term assets and short-term
liabilities.

`
`
`
`
` ` `
`
 DISCOUNTED CASH FLOW (DCF) ANALYSIS 123

For instance, certain figures are given as under Table 4.5:

TABLE 4.5: DATA GIVEN FOR

CALCULATING TERMINAL VALUE
Particulars Amounts
Forecasted free cash flows `250,000
Growth rate 3%
Discount rate 10%

The terminal value is computed as follows:

Forecasted free cash flows (1+growth rate )
Terminal value=
Discount rate (1–growth rate )

`250,000 (1 + 0.03 )
=
0.10 (1 − 0.03 )

=`2,654,639.18

SELF ASSESSMENT QUESTIONS

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1. Which of the following method is not applied while computing
the values of discounted cash flows?
a. Unlevered cash flow
b. Levered cash flow
c. Terminal value
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d. Payback period
2. Which statement is being analysed for determining the
number of free cash flows?
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a. Income statement
b. Accounting statements
c. Annual report
d. Expense statement

ACTIVITY

Analyse the accounting reports of any renowned company from the

internet and apply the techniques of discounted cash flows in it.
Make a report and mention your observations with practical for-
mulas.

4.3 PRESENT VALUE AND DISCOUNTING

To know the concept of resent value let us first discuss the concept
of the time value of money. The time value of money is defined as the
 `

NOTE
Future value is usually greater
than the value being placed
at the start of the project as it
increases over time and is also
subject to interest rates.

`
`

` `
 Study
Hint
A stub period is also referred
to as an interim or half period
consisting of six months in a
year.
 DISCOUNTED CASH FLOW (DCF) ANALYSIS 127

4.5 PERFORMING SENSITIVITY ANALYSIS

Sensitivity analysis analyses the effects of different values of an inde-
pendent variable on a certain dependent variable under a specified
set of assumptions. Sensitivity analyses, in other words, examine how MARK IT!
various sources of uncertainty in a mathematical model impact the
Both the corporate sector
model’s overall level of uncertainty. This method is applied within pre- and the study of economics
determined bounds that hinge on one or more input variables. use sensitivity analysis. It is
often referred to as a what-if
Sensitivity analysis can be used to aid in forecasting share prices for study and is frequently utilised
publicly traded corporations. Earnings of the company, the number by economists and financial
of outstanding shares, debt-to-equity ratios (D/E) and the number of experts.
competitors in the market are a few factors that have an impact on
stock prices. By changing the underlying assumptions or including
new variables, the analysis of future stock prices can be improved.
The impact of changing interest rates on bond prices can also be
ascertained using this model.

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The enterprise value of a company is determined by a discounted cash
flow analysis as the present value of its anticipated free cash flows.
The requirement to consider and forecast major business factors is the NOTE
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strength of DCF analysis. But even little modifications might result in Bond prices are the dependent
significant value fluctuations because DCF valuation is so dependent variable in this scenario,
whereas interest rates are the
on fundamental assumptions. Understanding the sensitivity of the independent variable.
DCF model to important assumptions requires sensitivity analysis of
critical variables.
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SELF ASSESSMENT QUESTIONS

7. Which of the following of an enterprise can be determined by

a discounted cash flow analysis?
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a. Enterprise value
b. Net present value
c. Changes in cash equivalents
d. DCF analysis
8. Which of the following cannot use sensitivity analysis?
a. Corporate sector
b Economic sector
c. Financial sector
d. Social sector

ACTIVITY

Discuss and analyse the applicability of sensitivity analysis in busi-

ness.
 DISCOUNTED CASH FLOW (DCF) ANALYSIS 129

CONSOLIDATED STATEMENT OF CASH

4.7
FLOWS (CSCF)
The financing, investment and operating cash flows of all majority-
owned, legally separate firms are combined in a consolidated cash
flow statement. As a result, you cannot consolidate general partner-
ships or sole proprietorships since they lack legal distinction. Because
it summarises all of the firm’s cash flows, a consolidated cash flow
statement is often thought to be more useful to review than individ-
ual cash flow statements. Consolidated cash flow statements must be
prepared by GAAP, just as individual business cash flow statements.

Consolidated financial statements are a collection of financial state-

ments that include the financials of the parent firm and all of its
interests. Consolidation is required by GAAP, or generally accepted
accounting principles, because examining the financials of each con-
nected company separately can produce an inaccurate representation NOTE

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of reality. The firm with the majority ownership is the parent com-
pany, sometimes known as the “controlling entity” in accounting.

A more realistic picture of overall performance can be obtained by

The term “controlled entity”
refers to a subsidiary or division.
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combining the parent company’s financials with those of any other
companies it owns.

If a parent submits their cash flow statement, a consolidated cash

flow statement is shown. As much as is practical, the consolidated

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financial statements are given in the same format as the parent’s sep-
arate financial statements.

The process of preparing a consolidated cash flow statement is to cre-

ate a separate cash flow statement for the main company as well as
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any applicable subsidiaries, majority-owned investments or joint ven-

tures first. Next, use a worksheet to adjust any line items to remove
intercompany sales and transfers. If you attempt to integrate data
while also making the edits directly on the statement, confusion may
arise. Add each cash flow statement after that, along with the modi-
fications from the spreadsheet. A consolidated cash flow statement is
the result.

The adjustments that are required to offset the net impact of inter-
company sales and transfers since consolidation combines all results
into one and there is no accounting rule permitting a company to sell
or transfer goods or services to itself. Your company must have the
majority of the outstanding stock, membership interests or limited
partner interests in a business for consolidation rules to be applicable.
Your corporation must exclude a company from the consolidation if it
exercises “voting control but not ownership control” over it but does
not own at least 50% of it.
NOTE
Operating, investment and
financing cash flows make up
the 3 main components of the
CSCF.
 Study
Hint
The real option charge is a
non-cash deduction and is
added back to the CSCF.
 DISCOUNTED CASH FLOW (DCF) ANALYSIS 133

The CSCF rewritten to free cash flow shown in Figure 4.2:

A B C D E F G
ABC CORPORATION
1 CSCF rewritten to Free Cash Flow (FCF)
2 2008 2009 2010 2011 2012
3 Operating Activities:
4 Net earnings 479,355 495,597 534,268 505,856 520,273
Adjustments to reconcile net earnings to net cash
5 provided by operating activities
6 Add back depreciation and amortization 41,583 47,647 46,438 45,839 46,622
7 Changes in operating assets and liabilities:
8 Subtract increase in accounts receivable 9,387 25,951 -12,724 1,685 -2,153
9 Subtract increase in inventories -37,630 -22,780 -16,247 -15,780 -5,517
Subtract increase in prepaid expenses and -52,191 13,573
10 other assets 16,255 14,703 -2,975
Add increase in accounts payable, accrued 29,612 51,172
11 expenses, pensions and other liabilities 6,757 40,541 60,255
12 Net cash provided by operating activities 470,116 611,160 574,747 592,844 616,505 <-- =SUM(F4:F11)
13
14 Investing Activities:
15 Short-term investments, net
16 Purchases of property, plant and equipment -48,944 -70,326 -89,947 -37,044 -88,426
Proceeds from dispositions of property, plant and
197 6,956 22,942 6,179 28,693
17 equipment
18 Net cash used in investing activities -53,747 -118,370 -67,005 -30,865 -59,733 <-- =SUM(F15:F17)
19
20 Financing Activities:
21 Repayment of debt
22 Proceeds from revolving credit facility borrowings
23 Proceeds from the issuance of stock
24 Dividends paid
25 Stock repurchased
26 Net cash used in financing activities <--
27
28
29
30
31
32
33
34
35
Free cash flow before interest adjustment
Add back after-tax net interest
Free cash flow (FCF)

Supplemental disclosure of cash flow information

Cash paid during the period for
Income taxes
Interest
416,369
54,537
470,906

255,043
83,553
492,790
61,658
554,448

175,972
83,551
507,742
44,271
552,013

314,735
70,351
561,979
36,620
598,599

283,618
57,151
S 556,772 <-- =F12+F18+F26
36,504 <-- =(1-F37)*F35
593,276 <-- =F28+F29

305,094
57,910
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36
37 Income tax rate 34.73% 26.20% 37.07% 35.92% 36.96% <-- =F34/(F4+F34)

Figure 4.2: CSCF Rewritten to Free Cash Flow

Source: [Link]

In another example, a company may be valued as shown in Figure 4.3:

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A B C D E F G H
1 ABC CORP. VALUATION
Free cash flow (FCF)
2 year ending 31 Dec. 2012 593,276 <-- 593275.77278229
3 Growth rate of FCF, years 1-5 8.00% <-- Optimistic about short-term growth
4 Long-term FCF growth rate 5.00% <-- More pessimistic about long-term growth
5 Weighted average cost of capital, WACC 10.70%
6
7 Year 2012 2013 2014 2015 2016 2017
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8 FCF 640,738 691,997 747,357 807,145 871,717 <-- =F8*(1+$B$3)

9 Terminal value 16,057,940 <-- =G8*(1+B4)/(B5-B4)
10 T otal 640,738 691,997 747,357 807,145 16,929,657 <-- =G8+G9
11
12 Enterprise value 13,063,055 <-- =NPV(B5,C10:G10)*(1+B5)^0.5
Add back initial cash and marketable
13 securities 73,697 <-- From current balance sheet
14 Subtract out 2012 financial liabilities 1,379,106 <-- From current balance sheet
15 Equity value 11,757,646 <-- =B12+B13-B14
16 Per share (1 million shares outstanding) 11.76 <-- =B15/1000000

Figure 4.3: Valuation of ABC Corp.

Source: [Link]

SELF ASSESSMENT QUESTIONS

13. Which of the following section is the compulsory section of

free cash flow?
a. Financing cash flow
b. Operating cash flow
c. Investing cash flow
d. Total cash flow
134 FINANCIAL MODELLING

14. ________________ is the part of free cash flow.

a. Productive investing activities
b. Financing activities
c. Sale of debentures
d. Sale of investment

ACTIVITY

Find out the difference between investment cash flow and financ-
ing cash flow.

FREE CASH FLOWS BASED ON PRO

4.9
FORMA FINANCIAL STATEMENTS

S
Building a set of predicted financial statements based on our knowl-
edge of the company and its financial statements is another method
for estimating free cash flows. Typical Pro Forma might resemble the
IM
one shown in Figure 4.4:
A B C D E F G
1 PRO FORMA FINANCIAL MODEL
2 Sales growth 10%
3 Current assets/Sales 15%
4 Current liabilities/Sales 8%
5 Net fixed assets/Sales 77%
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6 Costs of goods sold/Sales 50%

7 Depreciation rate 10%
8 Interest rate on debt 10.00%
9 Interest paid on cash and marketable securities 8.00%
10 Tax rate 40%
11 Dividend payout ratio 40%
12
13 Year 0 1 2 3 4 5
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14 Income statement
15 Sales 1,000 1,100 1,210 1,331 1,464 1,611
16 Costs of goods sold (500) (550) (605) (666) (732) (805)
17 Interest payments on debt (32) (32) (32) (32) (32) (32)
18 Interest earned on cash and marketable securities 6 9 14 20 26 33
19 Depreciation (100) (117) (137) (161) (189) (220)
20 Profit before tax 374 410 450 492 538 587
21 Taxes (150) (164) (180) (197) (215) (235)
22 Profit after tax 225 246 270 295 323 352
23 Dividends (90) (98) (108) (118) (129) (141)
24 Retained earnings 135 148 162 177 194 211
25
26 Balance sheet
27 Cash and marketable securities 80 144 213 289 371 459
28 Current assets 150 165 182 200 220 242
29 Fixed assets
30 At cost 1,070 1,264 1,486 1,740 2,031 2,364
31 Depreciation (300) (417) (554) (715) (904) (1,124)
32 Net fixed assets 770 847 932 1,025 1,127 1,240
33 Total assets 1,000 1,156 1,326 1,513 1,718 1,941
34
35 Current liabilities 80 88 97 106 117 129
36 Debt 320 320 320 320 320 320
37 Stock 450 450 450 450 450 450
38 Accumulated retained earnings 150 298 460 637 830 1,042
39 Total liabilities and equity 1,000 1,156 1,326 1,513 1,718 1,941

Figure 4.4: Pro Forma Financial Model

Source: [Link]
 DISCOUNTED CASH FLOW (DCF) ANALYSIS 135

The free cash flow can be calculated as follows using the concept of
free cash flow analysis as shown in figure 4.5:

A B C D E F G
41 Year 0 1 2 3 4 5
42 Free cash flow calculation
43 Profit after tax 246 270 295 323 352
44 Add back depreciation 117 137 161 189 220
45 Subtract increase in current assets (15) (17) (18) (20) (22)
46 Add back increase in current liabilities 8 9 10 11 12
47 Subtract increase in fixed assets at cost (194) (222) (254) (291) (333)
48 Add back after-tax interest on debt 19 19 19 19 19
49 Subtract after-tax interest on cash and mkt. securities (5) (9) (12) (16) (20)
50 Free cash flow 176 188 201 214 228

Figure 4.5: Free Cash Flow

Source: [Link]

Enterprise value can be calculated as shown in figure 4.6 using the

free cash flow calculated above.

53
54
55
56
Valuing the firm
A

W eighted average cost of capital

Long-term free cash flow growth rate
B

20%
5%
C D E F

S
G H
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57 Year 0 1 2 3 4 5
58 FCF 176 188 201 214 228
59 Terminal value 1,598 <-- =G58*(1+B55)/(B54-B55)
60 Total 176 188 201 214 1,826
61
62 Enterprise value, present value of row 60 1,348 <-- =NPV(B54,C60:G60)*(1+B54)^0.5
63 Add in initial (year 0) cash and mkt. securities 80 <-- =B27
64 Asset value in year 0 1,428 <-- =B63+B62
65 Subtract out value of firm's debt today (320) <-- =-B36
66 Equity value 1,108 <-- =B64+B65
67 Share value (100 shares) 11.08 <-- =B66/100
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Figure 4.6: Enterprise Value

Source: [Link]
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SELF ASSESSMENT QUESTIONS

15. ________ should be added back to the operating profit of the

company for the calculation of free cash flow.
a. Depreciation
b. Discount
c. Rent
d. Insurance
16. Which of the following should be subtracted from the profits
to come at the free cash flow figure of the company?
a. Depreciation expense
b. Increase in current liabilities
c. Increase in current assets
d. After-tax interest on debt
S
138 FINANCIAL MODELLING

6. ___________ period is also referred to as an interim or half period

consisting of six months in a year.
a. Bonds
b. Valuation
c. Stub
d. Swaps
7. The amount of cash generated by the company’s operations is
measured by its ___________.
a. Free Cash Flow (FCF)
b. Discounted Cash Flows (DCF)
c. Time Value of Money
d. CSCF
8. ___________ is similar to what-if study or analysis.

S
a. Sensitivity analysis
b. Historical analysis
IM
c. Tradable security analysis
d. Stub period
9. The rates of ___________ can be varied with the type of investment
security.
a. Discount
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b. Market
c. Investment
d. Growth
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10. The statement of ___________ is the third report that describes

the cash position of an organisation.
a. Profit and loss
b. Cash flows
c. Balance sheet
d. Income

4.12 DESCRIPTIVE QUESTIONS

?
1. Describe the sensitivity analysis in detail.
2. Explain the concept of present value and discounting.
3. Define the terminal value.
4. What is discounted cash flow analysis? Also, define the free cash
flow.
5. Elaborate the stub period.
 DISCOUNTED CASH FLOW (DCF) ANALYSIS 139

HIGHER ORDER THINKING SKILLS

4.13
(HOTS) QUESTIONS
1. Match the following:

List I List II

I. Investment in securities i. Operating cash flows, invest-

ment cash flows and financing
cash flows.

II. Sensitivity analysis ii. The present value of the future

FCFs discounted at the WACC

III. Enterprise value iii. Evaluates how various values

of an independent variable
impact a specific dependent
variable.

IV. Consolidated Statement of iv.

Cash Flows (CSCF)
S
The sale or the purchase of
securities held by the firm.
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Choose the right option.
a. I-i, II-iii, III-ii, IV-iv
b. I-iv, II-ii, III-i, IV-iii
c. I-i, II-iii, III-iv, IV-i
M

d. I-iv, II-iii, III-ii, IV-i

2. This is followed in such a way by adjusting the number of expected
cash flows concerning the date of entering into a transaction and
forecasting them to be obtained within the half-yearly term. It
N

is also referred to as an interim or half period consisting of six

months in a year. Choose the correct option.
a. Historical periods
b. Stub periods
c. Weighted Average Cost of Capital (WACC)
d. Discounting period
3. __________ represent the amount being spent on acquisition
of fixed assets and __________ represents the amount left after
deducting short-term assets and short-term liabilities.
a. Working capital, capital expenditure
b. Fixed assets, liquid assets
c. Capital expenditure, working capital
d. Goodwill, profit and loss account
140 FINANCIAL MODELLING

4.14 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topics Q. No. Answer

Discounted Cash Flow (DCF) 1. d. Payback period
Analysis
2 b. Accounting statements

Present Value and Discount- 3. a. Market value

ing
4. d. Accounting rate of return
Understanding Stub Periods 5. c. Bonds
6. c. Stub period

ysis S
Performing Sensitivity Anal- 7.

8.
a. Enterprise value

d. Social sector
IM
Cash Flows: DCF “Top Down” 9. c. Free cash flow
Valuation
10. a. WACC
Consolidated Statement of 11. c. In the case of group com-
Cash Flows (CSCF) panies
M

12. b. Intercompany cash flows

Free Cash Flows Based on 13. b. Operating cash flow
Consolidated Statement of
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Cash Flows (CSCF)

14. a. Productive investing
activities
Free Cash Flows Based on 15. a. Depreciation
Pro Forma Financial State-
ments
16. c. Increase in current assets

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. b. Profitable
2. c. Discount
3. a. Unlevered free cash flow
4. b. Growth rate
 DISCOUNTED CASH FLOW (DCF) ANALYSIS 141

Q. No. Answer
5. b. Present value
6. c. Stub
7. a. Free Cash Flow (FCF)
8. a. Sensitivity analysis
9. a. Discount
10. b. Cash flows

ANSWERS FOR DESCRIPTIVE QUESTIONS

1. A sensitivity analysis examines how different values of an
independent variable affect a certain dependent variable in
accordance with a particular set of assumptions. Sensitivity
analysis, in other words, examine how various types of uncertainty
in a mathematical model affect the level of uncertainty in the

Analysis
S
model generally. Refer to Section 4.5 Performing Sensitivity

2. Present value is referring to the amount that existed in the

IM
recent scenario. It is the amount which an investor has in their
hand before investing. For instance, a person who has $1,000 in
his hand is considered as current value unless he invests. Refer
to Section 4.3 Present Value and Discounting
3. Terminal value is the worth of an investment project that is
M

determined beyond the defined estimated period. Refer to

Section 4.2 Discounted Cash Flow (DCF) analysis
4. DCF Analysis is one of the techniques that are applied to measure
the value of current investment in future periods. It enables the
N

company to analyse the profitability of any long-term project

which can be the acquisition of any securities or any kind of fixed
asset whether it is tangible or intangible. It follows the concept of
the time value of money. Refer to Section 4.2 Discounted Cash
Flow (DCF) analysis
5. The stub period is referring to the time duration between
the starting of an accounting year and the date of making a
transaction. Refer to Section 4.4 Understanding Stub Periods

ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS

Q. No. Answer
1. d. I-iv, II-iii, III-ii, IV-i
2. b. Stub Periods
3. c. Capital expenditure, working capital
Valuation techniques
 C H A
5 P T E R

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

CONTENTS

5.1 Introduction
5.2

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Weighted Average Cost of Capital (WACC)
Self Assessment Questions
Activity
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5.3 Using the CAPM to Estimate the Cost of Equity
5.3.1 Estimating the Cost of Debt
5.3.2 Understanding and Analysing WACC
5.3.3 Concluding Valuation
Self Assessment Questions
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Activity
5.4 Computing the Value of the Firm’s Equity, E
5.4.1 Computing the Value of the Firm’s Debt, D
5.4.2 Computing the Firm’s Tax Rate, TC
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5.4.3 Computing the Firm’s Cost of Debt, rD

Self Assessment Questions
Activity
5.5 Two Approaches to Computing the Firm’s Cost of Equity, rE
Self Assessment Questions
Activity
5.6 Implementing the Gordon Model for rE
Self Assessment Questions
Activity
5.7 The CAPM: Computing the Beta, β
5.7.1 Using the Security Market Line (SML) to Calculate Merck’s
Self Assessment Questions
Activity
5.8 Cost of Equity, Ke/Ri.
Self Assessment Questions
Activity
144 FINANCIAL MODELLING

CONTENTS

5.9 Computing the WACC, Three Cases

5.9.1 Computing the WACC for Merck (MRK)
5.9.2 Computing the WACC for Whole Foods (WFM)
5.9.3 Computing the WACC for Caterpillar (CAT)
Self Assessment Questions
Activity
5.10 Summary
5.11 Multiple Choice Questions
5.12 Descriptive Questions
5.13 Higher Order Thinking Skills (HOTS) Questions
5.14 Answers and Hints
5.15 Suggested Readings & References

S
IM
M
N
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 145

INTRODUCTORY CASELET

WEIGHTED AVERAGE COST OF CAPITAL

The Weighted Average Cost of Capital (WACC) is useful to the

management or investors to arrive at an appropriate decision. Case Objective
For example, to evaluate different investment options, it is very This caselet study provides
important to use the relevant WACC with the help of which the a prelude to the Weighted
estimated future cash flows from available investment projects Average Cost of Capital
are converted into the present value of benefits by discounting (WACC).
them. Similarly, the WACC acts as the cut-off rate for appraising
and comparing the performance of a particular business project
against the hurdle rate. The WACC is used as a benchmark for
framing the firm’s credit and debt policies and for evaluating cap-
ital budgeting decisions. It is used to discount or compound the
cash flows or a stream of cash flows.

The WACC can be described in two ways, i.e., the explicit cost of

S
capital and the implicit cost of capital. The explicit WACC pertains
to the clear cash outflows of a firm towards the utilisation of capi-
tal, such as in the form of interest payment to debenture holders,
dividend payment to shareholders and repayment of the princi-
IM
pal loan amount to financial institutions. Conversely, the implicit
WACC pertains to the opportunity loss of foregoing a better invest-
ment option by choosing an alternative course and it is not a cash
outflow. For instance, when a firm uses its bank deposit for busi-
ness purposes which earns an interest of 9.5% p.a., it forgoes the
interest earnings from the bank on this deposit. The implicit cost
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of capital, in this case, shall be 9.5% interest that could have been
earned by not using the deposit for business purposes.

The WACC for each source of finance can be determined sepa-

rately, such as cost of equity, cost of preference share capital, cost
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of long-term debt and cost of retained earnings.

146 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

> Discuss the concept of Weighted Average Cost of Capital
(WACC)
> Estimate the equity costs using CAPM
> Utilise the common financial functions
> Explain the concluding valuation
> Describe the value of the firm’s equity, E
> Compute the firm’s cost of equity, rE, using various approaches
> Summarise the Gordon model for rE

5.1 INTRODUCTION
Quick Revision

S
In the previous chapter, you studied the Discounted Cash Flow (DCF)
analysis, unlevered free cash flow, forecasting free cash flow and fore-
casting terminal value. The chapter also gave insight into Present
value and discounting, stub periods, performing sensitivity analysis
IM
and DCF “Top Down” valuation of cash flows. In this chapter, you will
be apprised about Consolidated Statement of Cash Flows (CSCF),
free cash flows based on CSCF and free cash flows based on pro forma
financial statements.

A business organisation collates finance from its investors (both equity

M

and debt investors) and utilises those funds to generate returns. These
investors are thus assuming a risk by enforcing trust that the organ-
isation will spend their financial resources prudently. Subsequently,
investors require a return to compensate for owing the risk. This is
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what we infer as the “investors’ required return” or you can say that
the shareholders’ position is the shareholders’ required return.

To gauge the return, you tend to use Weighted Average Cost of Capital
(WACC), which infers the anticipated rate of return on a portfolio of all
the business entity securities. WACC can be harnessed as the hurdle
rate (cost of capital/discount rate) for appraising upcoming projects. A
project that provides a yield that is greater than the WACC is liable for
analysis (i.e., positive NPV) since it furnishes an amount in surplus of
that which would be required to recoup the investors.

The cost of capital of an investor, in finance parlance, is at par with

the return, an investor can yield from the next ideal alternative invest-
ment. In other words, it is the opportunity cost of investing the same
money in various investments entailing the same risk and associated
traits. From a financing perspective, WACC is simply the cost which
is paid for making use of the capital. In another way, it exhibits a
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 147

percentage return on investment that influences an investor to divert

money towards a particular project or company.

In place of their contribution to the total capital, the WACC is rep-

resented in terms of the return that long-term capital suppliers to a
business entity (such as shareholders, debenture holders, or lenders)
anticipate to receive as payment. When businesses get financing from
various sources, they are required to repay a sum of money in addition
to the principal, typically in the form of recurring interest payments.

In this chapter, you will study the Weighted Average Cost of Capital
(WACC), using the CAPM to estimate the cost of equity, estimating the
cost of debt, understanding and analysing WACC, concluding valua-
tion and aggregating the three methodologies. The chapter will give
insight into computing the Value of the Firm’s Equity, computing the
Firm’s tax rate and computing the firm’s cost of debt. You will also gain
knowledge of two approaches to computing the firm’s cost of equity.

S
You will also gain perspective on implementing the Gordon model.
Also, CAPM: Computing the Beta, β along with using the Security
Market Line (SML) to calculate Merck’s. Towards the end, you will
NOTE
The Weighted Average Cost of
Capital (WACC) serves as the
IM
discount rate for calculating the
get to know about computing the WACC, Three Cases, computing the Net Present Value (NPV) of a
WACC for Whole Foods (WFM) and computing the WACC for Cater- business.
pillar (CAT).

WEIGHTED AVERAGE COST OF CAPITAL

5.2
M

(WACC)
The average after-tax cost of capital of the firm from all sources which
consists of common stock, preferred stock and other forms of debt is
called the Weighted Average Cost of Capital (WACC). It is the typical
N

interest rate expected by the company to finance its assets.

The required rate of return is calculated using the popular method,

that is, the WACC because it reflects the return that both the bond-
holders and the shareholders are required to supply the firm with cap-
ital in a single value.

A company’s WACC is probably going to be greater if its stock is

extremely volatile or if its debt is seen as risky since investors will
expect bigger returns.

WACC and its formula are used by all analysts, investors and firm
management for a variety of purposes. The cost of capital of the com-
pany is significant to calculate in corporate finance for different rea-
sons. For example, a corporation may calculate its net present value
using the WACC discount rate.
148 FINANCIAL MODELLING

WACC is crucial when assessing the advantages of taking on new ini-

tiatives or buying an existing company. A merger is probably a wise
decision for the firm if it thinks it will, for example, create a return
greater than its cost of capital. Its management will want to deploy its
cash more wisely if they predict a return that will be less than what its
investors are hoping for.

The cost of capital becomes a crucial factor in determining a firm’s

potential for net profitability since the majority of enterprises rely on
borrowed money to operate. The cost of capital for a corporation is
calculated using its WACC. Both the company’s debt and equity are
taken into account in the WACC formula’s computation.

A lower WACC often implies a robust company that may draw inves-
tors at a reduced cost. A greater WACC, on the other hand, is often
associated with enterprises that are seen to be riskier and need to
reward investors with larger returns.

Know More
The WACC is the rate at which
future cash flows must be
S
Calculating a company’s cost of capital would be relatively easy if
it only received funding from one source, such as common stock. If
investors believed they would receive a 10% return on their invest-
IM
ment in exchange for their shares, the firm’s cost of capital would be
discounted for a firm in order
to determine the current value
the same as its cost of equity or 10%. The cost of debt, for instance,
of the company. It depicts how would be 5% if the corporation received an average return of 5% on
the cash flows are thought to its existing bonds.
be risky.
SELF ASSESSMENT QUESTIONS
M

1. Which of the following is calculated using the popular method,

that is, the Weighted Average Cost of Capital (WACC) because
it reflects the return that both the bondholders and the
shareholders are required to supply the firm with capital in a
N

single value?
a. Required rate of return
b. Cost of capital
c. Risk-free return
d. None of these
2. Which of the following is crucial when assessing the advantages
of taking on new initiatives or buying an existing company?
a. Cost of capital
b. WACC
c. Required rate of return
d. Risk-free return
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 149

ACTIVITY

Find out the advantages of Weighted Average Cost of Capital

(WACC).

USING THE CAPM TO ESTIMATE THE

5.3
COST OF EQUITY
A financial model used to determine an asset’s anticipated rate of
return is known as the capital asset pricing model (CAPM). The pre-
dicted returns on the market and a risk-free asset, as well as the asset’s
correlation with or sensitivity to the market, are used by CAPM to
achieve this (beta).

The cost of shareholder equity is calculated using the Capital Asset

Pricing Model (CAPM) by corporate accountants and financial ana-

S
lysts when preparing capital budgets. The CAPM is often used to price
risky securities, generate anticipated returns for assets given the asso-
ciated risk and determine the cost of capital. It is defined as the link
between systematic risk and expected return for assets.
IM
CAPM is calculated by using the below formula:

E(Ri) = Rf + βi(E(Rm) – Rf)

E(Ri) = Capital asset expected return

M

Rf = Risk-free rate of interest

βi = Sensitivity

E (Rm) = Expected return of the market

N

The Weighted Average Cost of Capital (WACC) includes the cost of

equity as a fundamental component. The entire projected cost of all
capital under various financing schemes is often calculated using the
WACC. In an attempt to determine the most economical combination
of debt and equity financing, WACC is often utilised.

Let us say Company XYZ has a 15% rate of return and trades on the NOTE
S&P 1,000. With a beta of 1.5, the company’s stock is somewhat more The link between systematic
erratic than the general market. Based on a three-month T-bill, the risk, or the broad risks of
investing, and expected return
risk-free rate is 7.5%. for assets, particularly stocks, is
described by the Capital Asset
The cost of the company’s equity financing is 18.75% based on this Pricing Model (CAPM).
information.

RISK-FREE RATE

The Risk-Free Rate (rf) is the theoretical rate of return received on

zero-risk assets, which serves as the minimum return required on risk-
150 FINANCIAL MODELLING

ier investments. The rate should reflect the yield to maturity (YTM) on
default-free government bonds of equivalent maturity as the duration
of the projected cash flows.

Real risk free rate is calculated by using below formula:

1 + Nominal Rf Rate
Real risk-free rate =
1+Inflation Rate

Nominal Risk-free Rate = (1 + Real Rf Rate) × (1 + Inflation Rate) – 1

First, here’s the formula:

Real Risk-Free Rate = Risk-Free Rate – Inflation Premium

Example: Say you’d like to invest in a 12-month certificate of deposit

(CD) that yields 2.50%. If the current risk-free rate is 2.04%—the yield
of a 12-month T-bill—you’re coming out almost half a percentage point

S
ahead of the T-bill with the CD. Great work! Or is it?

Let’s suppose the inflation rate is the same as it was in May 2022: 8.3%.
Now, do the math again.
IM
Real Risk-Free Rate = 2.04% – 8.3%

So the real risk-free rate is -6.26%. By investing in the CD, you’d be

falling 6.26% short of keeping Cost of Equity = Risk-Free Rate of
Return + Beta × (Market Rate of Return - Risk-Free Rate of Return)
current inflation rates.
M

Cost of Equity = Risk-Free Rate of Return + Beta × (Market Rate of

Return – Risk-Free Rate of Return)

= 7.5% + (1.5 × (15% – 7.5%))

N

= 18.75%

5.3.1 ESTIMATING THE COST OF DEBT

The effective interest rate that a business pays on its obligations,

such as bonds and loans, is known as the cost of debt. The cost of
debt may be expressed as either the before-tax cost of debt, which is
the amount owed by the business before taxes or the after-tax cost of
debt. The fact that interest charges are tax deductible accounts for the
majority of the difference between the cost of debt before and after
taxes.

The capital structure of the company consists of both the debt and
the equity. The capital structure of a company refers to how it uses
various funding sources, including debt, such as bonds or loans, to
support its overall operations and growth.
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 151

Understanding the entire rate that a firm pays to employ different

kinds of debt financing is made easier with the assistance of the cost Know More
of debt measure. Because riskier businesses often have higher loan The compensation a business
costs, the metric may also provide investors with a sense of how risky gives to its creditors and debt
holders is known as the cost
the firm is in comparison to others. of debt. In order to cover any
risk exposure associated with
There are a few different approaches to determining a company’s cost lending to a firm, these capital
of debt. sources must be paid.

The after-tax cost of debt may be calculated by multiplying the for-

mula (Risk-free Rate of Return + Credit Spread) by the (1 - Tax Rate).
The theoretical rate of return for investment with zero risk is known
as the risk-free rate of return and it is most often used for the U.S.
Treasury bonds. The term “credit spread” refers to the yield differen-
tial between the U.S. Treasury bond and another financial instrument
with the same maturity but a different credit grade.

S
This method is helpful since it considers changes in the economy as
well as the debt load and credit score relevant to the organisation. The
credit spread will be bigger if the firm has more debt or a worse credit
rating.
IM
Let us take an example where the company’s credit spread is 6%, risk-
free rate of return is 2.5% and its pre-tax cost of debt is 7%, if the tax
rate is 40 per cent.

Solution:
M

The cost of debt after taxes is 5.1% or [(0.025 + 0.06) × (1 - 0.40)].

A corporation might figure out the total amount of interest it is pay-

ing on each of its obligations for the year as an alternate method of
N

calculating the after-tax cost of debt. The risk-free rate of return and
the credit spread from the formula above is included in the interest
rate that a firm pays on its loans since the lender(s) will consider both
when originally computing an interest rate.

The amount of interest paid by the business for the year is divided
by the sum of its debt. This represents the company’s overall average
interest rate on debt. The average interest rate is multiplied by the
(1 - tax rate) for the calculation of the after-tax cost of debt.

For example: A business had an `3,00,000 loan with an 8% interest

rate and an `10,00,000 million loan with a 4% interest rate. The aver-
age interest rate is 4.92%, which is [(`10,00,000 × 0.04) + (`300,000 ×
0.08)] ÷ `13,00,000, or the pre-tax cost of debt. The tax rate for the
business is 40%. Therefore, its cost of debt after taxes is 2.95%, or
[0.0492 × (1 - 0.40)].
152 FINANCIAL MODELLING

5.3.2 UNDERSTANDING AND ANALYSING WACC

The WACC of a company is a measure of its total cost of capital, which

includes debt, common shares and preferred shares. Each sort of cap-
ital’s cost is multiplied by how much of the overall capital it makes up.

WACC is used in financial modelling as the discount rate to determine

a business’s net present value.

WACC’s formula is as follows:

WACC = (E/V × rE) + ((D/V × rD) × (1 – T))

Where,
E = market value of the firm’s equity (market cap)
D = market value of the firm’s debt
V = total value of capital (equity plus debt)

S
E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
IM
rE = cost of equity (required rate of return)
rD = cost of debt (yield to maturity on existing debt)
NOTE
The Weighted Average Cost of T = tax rate
Capital (WACC), which includes
ordinary stock, preferred stock, Following is an expanded version of the WACC formula that incorpo-
M

bonds, and other types of debt, rates the price of preferred stock (for companies that have it):
is the average after-tax cost
of capital for a company. The WACC = Cost of Equity × % Equity + Cost of Debt × % Debt × (1 –
WACC is the typical interest
rate that a business anticipates
Tax Rate) + Cost of Preferred Stock × % Preferred Stock
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paying to finance its assets.

Based on the ratio of equity, debt and preferred stock a firm possesses,
the WACC’s goal is to calculate the cost of each component of the cap-
ital structure. Each element costs the firm money.

The interest rate on the company’s debt is fixed, and the yield on its
preferred stock is also set. Even if a company’s return on common
stock is not predetermined, equity holders are often paid dividends in
the form of cash.

Since the WACC is a crucial component of a DCF valuation model, it is

crucial for finance professionals to comprehend this idea, particularly
those who work in investment banking and corporate development.

WACC PART 1 – COST OF EQUITY

The Capital Asset Pricing Model (CAPM), which compares rates of

return to volatility, is used to determine the cost of stock (risk vs.
reward).
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 153

The cost of equity formula is as follows:

rE = rF + β × (rM − rF)

Where,

rF = the risk-free rate (typically the 10-year U.S. Treasury bond yield)

β = equity beta (levered)

rM = annual return of the market

An implied cost or opportunity cost of capital is the cost of equity. It is

the rate of return that, in principle, investors need to be compensated
for the risk involved in stock investments. The beta measures how
volatile a stock’s returns are compared to the market as a whole (such
as the S&P 500).

RISK-FREE RATE

S
The return that may be obtained by investing in an asset that carries
no risk, such as the U.S. Treasury bonds, is known as the risk-free
IM
rate. The risk-free rate is typically calculated using the yield of the
10-year US Treasury.

EQUITY RISK PREMIUM (ERP)

Equity Risk Premium (ERP) is the additional yield that may be obtained
M

by investing in the stock market above the risk-free rate. Subtract- NOTE
ing the risk-free return from the market return is a straightforward The extra return that stock
method for estimating ERP. Usually, this information is sufficient for market investing offers above
most simple financial analyses. ERP estimation may, however, be a far a risk-free rate is referred to as
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more complex undertaking in practice. Banks often adopt ERP from the equity risk premium.
a journal called Ibbotson’s.

LEVERED BETA

The term “beta” describes how volatile or risky a stock is in compari-

son to all other equities on the market. There are several methods for
calculating a stock’s beta.

The first and easiest method is to determine the company’s history

beta (using regression analysis) or simply to use Bloomberg to get the
company’s regression beta.

The second and more comprehensive method is to update the beta

calculation using similar public business data.

This method involves calculating each company’s unlevered beta after

obtaining the beta of similar firms from Bloomberg.
154 FINANCIAL MODELLING

The unlevered beta is calculated by using below formula:

Unlevered Beta = Levered Beta ÷ (1 + (1 – Tax Rate) × (Debt ÷

Equity))

Know More Levered beta takes into account both company risk and debt-related
In order to quantify this systemic risk. Unlevered beta (asset beta), however, is computed to eliminate
risk, CAPM was developed. It is extra risk from debt to examine pure business risk since various
frequently used in the financial organisations have varied capital structures.
industry to value hazardous
securities and calculate
The capital structure of the firm being appraised is then taken into
projected returns for assets
given their risk and cost of account when calculating and re-levying the average of the unlevered
capital. betas.

The levered beta is calculated by using below formula:

Levered Beta = Unlevered Beta × ((1 + (1 – Tax Rate) × (Debt /

Equity))

S
When beta is re-levered, the firm’s present capital structure is often
used. Beta would then be re-levered using the firm’s goal capital
structure if there was any indication that the capital structure of the
IM
company would change in the future.

After determining the equity risk premium, risk-free rate and lever-
aged beta, The Cost of Equity = Risk-free Rate + Equity Risk Pre-
mium × Levered beta. Figure 5.1 shows the slope of the line:
M

Beta = Slope of the Line

N

Market (% change)

Share (% change)

Figure 5.1: Slope of the Line

 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 155

WACC PART 2 – COST OF DEBT AND PREFERRED STOCK

The simplest element of the WACC calculation is arguably calculat-

ing the cost of debt and preferred shares. The yield on the company’s
debt is the cost of debt, while the yield on the preferred stock is the
cost of preferred stock. Just multiply the preferred stock yield and the
proportion of debt and preferred stock in the capital structure of the
company.

The cost of debt must be multiplied by (1 - Tax rate), which is referred

to as the value of the tax shield since interest payments are tax deduct-
ible. Because preferred dividends are paid from after-tax earnings,
this is not done for preferred shares.

The after-tax cost of debt to be utilised in the WACC calculation is

obtained by multiplying the weighted average current yield to matu-
rity of all existing debt by one less the tax rate.

5.3.3 CONCLUDING VALUATION

S
Forecasting a company’s Free Cash Flow (FCF) into the future and
IM
discounting it to its Net Present Value (NPV) at the WACC is known as
financial modelling and valuation. Alternative techniques of valuing
include previous deals and examination of similar companies. These
techniques are used to value businesses in preparation for mergers,
purchases and capital raising.
M

The technique of valuation analysis is used to determine the rough

value or worth of any item, including businesses, stocks, fixed-income
securities, commodities, real estate and other assets. For various asset
types, the analyst may use various methodologies to value research,
but a common theme will be a focus on the fundamentals of the asset.
N

A certain amount of art and science go into value research since the
analyst must make assumptions regarding model inputs (number
crunching). In essence, the value of an asset is determined by the NOTE
Present Value (PV) of all projected future cash flows. For instance, the The conclusion of value may be
estimating model for a business includes a number of assumptions expressed as a single value or a
range of values
regarding sales growth, margins, financing choices, capital expendi-
tures, tax rates, discount rates for the PV calculation, etc.

After the model is created, the analyst may play about with the
variables to see how valuation changes when other hypotheses are
included. Not all asset classes can be included into one model. While
a real estate company would be best modeled with current net operat-
ing income (NOI) and capitalisation rate (cap rate) and a manufactur-
ing company may be amenable to a multi-year DCF model, commodi-
ties like iron ore, copper, or silver would be subject to a model focused
on global supply and demand forecasts.
156 FINANCIAL MODELLING

? DID YOU KNOW SELF ASSESSMENT QUESTIONS

Investors anticipate receiving 3. The cost of shareholder equity is calculated using which of
compensation for the time value
the following model by corporate accountants and financial
of money and risk. The time
value of money is taken into analysts when preparing capital budgets?
consideration by the risk-free a. Weighted Average Cost of Capital
rate in the CAPM calculation.
The other elements of the CAPM b. Capital asset pricing model
formula take the investor’s
increased risk into account. c. Cost of capital
d. Risk-free return
4. Forecasting a company’s __________ into the future and
discounting it to its Net Present Value (NPV) at the Weighted
Average Cost of Capital (WACC) is known as financial
modelling and valuation.
a. Discounted Cash Flow (DCF)

S
b. Free Cash Flow (FCF)
c. Both a. and b.
d. None of these
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5. Which of the following is the cost of equity; is the rate of return
that, in principle, investors need to be compensated for the
risk involved in stock investments?
a. Sunk cost b. Opportunity cost
c. Product cost d. None of these
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6. Which of the following describes how volatile or risky a stock

is in comparison to all other equities on the market?
a. Levered beta
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b. Unlevered beta
c. Risk-free Rate
d. Equity Risk Premium (ERP)

ACTIVITY

Discuss the limitations of the cost of equity.

COMPUTING THE VALUE OF THE FIRM’S

5.4
EQUITY, E
The value of the company’s equity may be calculated in the simplest
of all WACC calculations: Take E to be the product of the number of
shares outstanding times the current share price as long as the firm is
publicly traded.
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 157

Take Red Bull & GoPro Partners, a corporation listed on the New York
Stock Exchange that owns gas pipelines and gas storage facilities, as
an example. There are `2,10,00,000 shares of EPB outstanding as of
July 30, 2021, at an `55 share price. The corporation is worth Equity of
`1,15,50,000 which is shown in Figures 5.2 and 5.3:

Figure 5.2: Formula used in Computation of the Value of Equity

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Figure 5.3: Computation of the Value of Equity
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5.4.1 COMPUTING THE VALUE OF THE FIRM’S DEBT, D

The market value of the company’s financial debt less the market
value of its surplus liquid assets is used to calculate the debt value of
the company. The amount of the company’s debt on the balance sheet,
less the value of the firm’s cash holdings and less the value of its mar-
M

ketable securities, is a popular estimate for this quantity. Figures 5.4

and 5.5 provide illustrations for Delta:
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Figure 5.4: Formula used in Calculating Net Debt

Figure 5.5: Computation of Net Debt

To calculate the WACC, additional debt-related things such as pension

obligations and deferred taxes are not included in our definition of
158 FINANCIAL MODELLING

debt. Although we include them as debts, it is difficult to assign a cost

to them. Instead, we choose to use solely financial commitments net of
liquid assets to approximate the WACC.

A corporation may have negative net debt, which happens when it has
more cash on hand and marketable securities than debt. We set D in
the WACC calculation to be negative in this case. Examples include
Intel and Whole Foods Markets in Figures 5.6 and 5.7:

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Figure 5.6: Formula using in Calculating Debt
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Figure 5.7: Computation of Debt

5.4.2 COMPUTING THE FIRM’S TAX RATE, TC

The firm’s marginal tax rate should be measured using TC in the

WACC calculation, however, it is typical to do so by calculating the
firm’s reported tax rate. Typically, this shouldn’t be an issue, as shown
by the Figures 5.8 and 5.9:

Figure 5.8: Formula used in Calculating Tax Rate

 Know More
The effective interest rate that a
business pays on its obligations,
such as bonds and loans, is
known as the cost of debt. The
cost of debt may be expressed
as either the before-tax cost of
debt, which is the amount owed
by the business before taxes, or
the after-tax cost of debt.
 Know More
The effective after-tax rate that
a borrower pays on its loan is
known as the cost of debt. The
cost of preferred stock and the
cost of equity make up the other
two elements of a company’s
total cost of capital, which
includes the cost of debt.
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 161

Figure 5.13: Computation of Cost of Debt

It is crucial to include all financial debt in the calculation of the aver-

age cost of debt (rD) based on the financial accounts, without making
a distinction between short-term and long-term obligations. Liquid
assets such as cash and its equivalents are treated as negative debt
and are subtracted from the firm’s debt. The concept behind this is

S
that the company might utilise some of its cash to pay off some of its
debt, leaving the remaining amount as the firm’s actual debt financ-
ing. The application of this specific theory, however, is primarily a
matter of judgement, we may not want to calculate the firm’s cost of
IM
borrowing instead of the interest it earns on cash, and we might not
want to assign all cash to the potential of paying off debt.

If we were to anticipate Indian Steel’s future cost of debt using its

average cost of debt, we most likely would use its present cost, rD =
4.76%, in the WACC calculation. This is due to our conviction that past
M

debt expenses are not very indicative of future expenditures.

CASH RAISES THE COST OF DEBT: THE CASE OF MERCK

N

The average cost of debt, based on net interest and net debt, is greater
than the cost of borrowing when a corporation has cash holdings that
generate less interest than the cost of borrowing.

Assume that the interest rate on cash is lower than the interest rate on
debt to observe this:
Interest Paid – Interest Earned
Average Cos t of debt =
Debt – Cash

Debt × iDebt – Cash × iCash Debt × iDebt – Cash × ( iCash − ε )

= =
Debt – Cash Debt – Cash

=
(Debt − Cash ) × iDebt + ε × Cash
Debt − Cash

Cash
= iDebt + × ε > iDebt
Debt − Cash
162 FINANCIAL MODELLING

The Figures 5.14 and 5.15 below show Merck’s spectacular perfor-
mance:

Figure 5.14: Formula used in Calculating Merck Cost of Debt

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Figure 5.15: Calculation of Merck Cost of Debt

In 2021, Merck’s borrowing costs were 4.23%, but the company made
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a respectable 1.46% on its significant cash and short-term investment

assets. We may incorrectly conclude that this shows that there is debt
between these two numbers, which represents Merck’s normal net
cost. Rather, the calculations demonstrate that rD = 13.38%
Average Net Interest Paid 2020 2021
rD =
Average Net Debt 2020 2021
5,50,000
=
41,12,000

= 13.38%

This estimate of rD takes into account the expenses associated with

maintaining large liquid asset reserves that provide such meagre
financial returns. Merck would have benefitted its shareholders from
a strictly financial standpoint by utilising the liquid assets to repay its
debt or by paying them out as dividends or share repurchases.

What figure would we use in the WACC equation to indicate the mar-
ginal cost of borrowing? This relies on how we see Merck’s financial
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 163

strategy: 13.38% can be a plausible estimate of the cost of debt if we

assume that the company will continue to maintain high levels of
financial debt while also building up its cash reserves. On the other
hand, if we assume that Merck’s marginal debt financing consists only
of debt, without a concurrent accumulation of cash, then rD should be
closer to 4%.

Method 2: rD as the Rating-Adjusted Yield for Merck

Another technique to calculate Merck’s borrowing costs is to extrap-

olate the marginal cost of its loan from a yield curve for the relevant
debt. Merck has ratings from Fitch of A +, Standard & Poor’s of
BBB + and Moody’s of BAA2. We get information for more than 1,000
A-Fitch rated bonds from Yahoo; most of this information is buried in
Figure 5.16:

S Know More
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The free cash flow yield for
Merck’s most recent twelve
months is 6.3%. From the fiscal
years ending in December 2017
through 2021, Merck’s free
cash flow yield averaged 3.8%.
From the fiscal years ending in
December 2017 through 2021,
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Merck’s had a median free cash

flow yield of 3.9%.
Figure 5.16: Calculation of Fitch Rate

These statistics are graphed, which either demonstrates that they

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cover a broad range of real credit risks or that the market is inefficient
as shown in Figure 5.17:
10% Term Structure, A Bonds, 17 August 2022

8%

6%

4%

2% y = 8E-06x3- 0.0004x2+0.008x + 0.0005

R2 = 0.4895

0%
5 10 15 20 25 30 35
Bond Maturity
-2%

Figure 5.17: Term Structure of a Bond Maturity

164 FINANCIAL MODELLING

About 50% of the variability of the yields as a function of time to matu-

rity is described by the polynomial regression line. The cost of bor-
rowing for Merck is 3.96% when using this regression equation and
assuming a 7-year average term for its debt as shown in Figures 5.18
and 5.19:

Figure 5.18: Formula used in Calculating Merck’s r D

from the A-Yield Curve

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Figure 5.19: Calculation of Merck’s r D from the A-Yield Curve
IM
SELF ASSESSMENT QUESTIONS

7. Which of the following of the company’s financial debt less the

market value of its surplus liquid assets is used to calculate
the debt value of the company?
M

a. Current value b. Historical value

c. Market value d. None of these
8. Which of the following are treated as negative debt and are
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subtracted from the firm’s debt?

a. Non-current assets b. Liquid assets
c. Non-current liabilities d. Fixed assets

ACTIVITY

Write a short note on the importance of the Firm’s Equity.

TWO APPROACHES TO COMPUTING THE

5.5
FIRM’S COST OF EQUITY, RE
The Weighted Average Cost of Capital (WACC) is calculated as follows:
WACC = E / (E + D) × rE + E / (E + D) × rD × (1 – TC). We have already
covered the estimate of four of the five WACC equation parameters in
this chapter: E, D, TC and rD. The calculation of the cost of equity, or rE,
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 165

is the most challenging of the calculations linked to the WACC param-

eters. There are two methods for computing rE that are simple to use:

According to the Gordon dividend model, rE is calculated based on the

current dividend, Div 0, the stock price, P 0 and the expected growth
of future dividends, g:

Div 0 (1 + g )
rE = +g
P0

The anticipated return on the market E (rM), the risk-free rate rf and a
firm-specific risk measure are used in the capital asset pricing model
(CAPM) to calculate rE:
rE = rF + β [E(rM) – rF]

Where,

rF = the market risk-free rate of interest

E (rM) = the expected return on the market portfolio

S NOTE
The return needed by either
IM
a business or an individual to
Cov ( rstock , rM ) justify an investment in equity is
β = a firm-specific risk measure = known as the cost of equity.
Var ( rM )

SELF ASSESSMENT QUESTIONS

M

9. According to the Gordon dividend model, rE is calculated

based on
a. Current dividend
b. Ex-dividend
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c. Both a. and b.
d. None of these

ACTIVITY

Find some more examples to calculate the cost of equity.

IMPLEMENTING THE GORDON MODEL

5.6
FOR RE
The Gordon Dividend Model uses the following deceptively simple
sentence to calculate the cost of equity:

The present value of a share’s projected future dividend stream, dis-

counted at the appropriate risk-adjusted cost of equity (rE), is what
determines the share’s worth.
166 FINANCIAL MODELLING

When dividend growth is expected to remain constant in the future,

the Gordon model may be used with ease. If the present stock price
is P0, the current dividend is Div 0 and the predicted growth rate of
future dividends is g, then these factors are all true. According to the
Gordon model, the stock price is equal to the future dividends that
have been discounted (at the appropriate cost of equity, rE):

Div 0 (1 + g ) Div 1 × (1 + g ) Div 1 × (1 + g ) Div 1 × (1 + g )

2 3 4

P0 = + + + ...
1 + rE (1 + rE ) 2
(1 + rE ) 3
(1 + rE )4
Div 0 × (1 + g )
∞ t

=∑
t=1 (1 + rE )t
Div 0 × (1 + g )
∞ t

Provided that | g | < rE, the expression = ∑ can be

t=1 (1 + rE )t
Div 0 (1 + g )
reduced to
S
rE − g
(We will save you from reading this derivation,

which is based on a geometric series formula typically covered in high

school.) Thus, we obtain the Gordon model cost of equity given a con-
IM
stant expected dividend growth rate as follows:
Div 0 (1 + g ) , provided |g| < r
P0 = E
rE − g

The Gordon formula for the cost of equity may be found by solving the
M

? DID YOU KNOW aforementioned equation for r E:

When evaluating a company’s
shares, the Gordon Growth Div 0 (1 + g )
Model (GGM) makes the rE = + g, provided |g| < rE
P0
assumption that it will always
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exist and that dividends will rise

steadily. Note the proviso after this equation: For the infinite sum on the first
line of the formula to have a finite solution, the dividend growth rates
must be lower than the discount rate. In our analysis of the Gordon
model with supernormal growth rates, we go back to the condition
when this is false as shown in Figure 5.20. Consider a company whose
share price is P0 = `50 and whose current dividend is Div 0 = `3 per
share to use this formula. Let us say it is projected that the dividend
will increase by 12% annually. The firm’s cost of equity is 17.6% at that
point as shown in Figures 5.21:

Figure 5.20: Formula using in Calculating Gordon

Model Cost of Equity
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 167

Figure 5.21: Computation of Gordon Model Cost of Equity

Using the Gordon Model to Compute the Cost of Equity for Merck

The 10-year dividend history of Merck is shown here, take notice that
part of the data has been obscured when we apply the Gordon model
to this company as shown in Figures 5.22 and 5.23:

S
IM
Figure 5.22: Formula used in Calculating Merck Dividend History
M
N

Figure 5.23: Computation of Merck Dividend History

Depending on the time frame used, the historical dividend growth

rate for Merck might be either 1.55% or 2.02%. Which of these rates is
a better predictor of future expected dividend growth rates to calcu-
late the cost of equity rE? We take into account both scenarios in the
P `
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 169

For Merck, we consider the data below as in Figures 5.25 and 5.26:

S
IM
Figure 5.25: Formula used in Calculating Golden Model Merck’s Eq-
uity Pay-outs
M
N

Figure 5.26: Computation of Golden Model Merck’s Equity Pay-outs

170 FINANCIAL MODELLING

Merck’s cost of equity is rE = 19.46% if we assume that its historical

growth rate of cash flow to equity, which is 13.71%, would continue
indefinitely. This seems a little excessive.

“Supernormal Growth” and the Gordon Model

Div 0 (1 + g )
A basic condition of the Gordon formula rE = + g is the cir-
P0
cumstance | g | rE. In financial instances, breaches of | g | rE often
happen for very fast-growing enterprises, where we predict extremely
high growth rates, at least temporarily, such that g > rE. The origi-
nal dividend discount calculation demonstrates that P0 would have an
endless value if such “supernormal” growth were to continue over the
* (1 + g )
t
∞
Div 0 ×
long term because when g > rE, the expression ∑ =∞
t=1 (1 + rE )t

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As a result, a period of very high dividend growth rates (where, g > rE)
must be followed by a time where the long-term growth rate of divi-
dends is lower than the cost of equity, where g rE
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Let us say that the company expects to pay high-growing dividends for
periods 1... and m and that the dividend growth rate would be reduced
for years after that.

The deferred value of these predicted future pay-outs may be

M

expressed as follows:

Share value today = Present value of dividends

Div 0 *× (1 + g 1 ) Div 5 *× (1 + g 2 )
t t−m
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m m
=∑ + ∑
t=1(1 + rE ) 

t
( 1 + rE )
t= m +1


t


↑ ↑
PV of m years of PV of remaining
high − growth g1 normal − growth g2
dividends dividends

Finding the cost of equity rE from expected growth rates is often a

challenge. In the example below, we calculate rE, which equalises the
values on both sides of the equation, using the VBA function Two
Stage Gordon.

According to the presumption, a company’s share price is currently

P0 = 30, its dividend is D0 = 3, and after five years of 35% dividend
growth, the dividend growth rate will slow to 8%.
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 171

In Figure 5.27, you can see that rE = 32.76%:

Figure 5.27: Calculation of the Golden Model with Two Growth Rates

SELF ASSESSMENT QUESTIONS

10. Which of the following is expected to remain constant in the

future, the Gordon model may be used with ease?
a. Dividend growth
b. Predicted growth
c. Future dividends
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d. All of these

ACTIVITY

Discuss with your team the limitations of the Gordon Model.

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5.7 THE CAPM: COMPUTING THE BETA, β

The Capital Asset Pricing Model is the only feasible alternative to the
Gordon model for calculating the cost of capital (CAPM). It is also the
N

cost of equity model that is used the most due to its beautiful theoret-
ical design and simple implementation. The CAPM’s connection with
market return determines the company’s cost of capital. For the firm’s
cost of equity, the standard CAPM calculation is as follows:

E =Frf + β  E ( rM ) − r
rE r= r +  rFf 

Where,
rF = the market risk-free rate of interest
NOTE
E (rM) = the expected return on the market portfolio The Capital Asset Pricing
Model (CAPM) is an idealised
Cov ( rStock , rM ) representation of how securities
β = a firm-specific risk measure =
Var ( rM ) are valued in financial markets,
which in turn establishes
projected returns on capital
The remaining portion of this part focuses on calculating the firm; investments.
the subsequent section demonstrates how to use the CAPM to get the
firm’s cost of equity rE.
NOTE
Beta is the Regression
Coefficient of the Firm’s Stock
Returns on the Market Returns

Merck,
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 175

justed method results in a somewhat higher cost of equity for Merck

as shown in Figure 5.30:

Figure 5.30: Computation of the Cost of Equity for

Merck Tax-adjusted CAPM

Even though the tax-adjusted CAPM is more consistent with a taxed

economy, we must admit that the tax-adjusted CAPM may not be

S
more valuable given the uncertainty surrounding the cost of capital
calculations.
IM
SELF ASSESSMENT QUESTIONS

11. Which of the following is determined using the securities

market line (SML) in the capital asset pricing model?
a. Risk-free rate of return
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b. Market return
c. Market premium return
d. Risk-adjusted cost of capital
N

ACTIVITY

Write a short note on the uses of the capital asset pricing model.

5.8 COST OF EQUITY, KE / RI

The return a business needs to determine if an investment satisfies
capital return criteria is known as the cost of equity. It is often used by
businesses as a cap for the needed rate of return.

The price the market is willing to pay to possess an asset and assume
ownership risk is known as a company’s cost of equity. The Capital
Asset Pricing Model (CAPM) and the dividend capitalisation model
are the two conventional formulas for calculating the cost of equity.
176 FINANCIAL MODELLING

The cost of equity according to the dividend capitalisation model is:

DPS
Cost of Equity = + GRD
CMV

Where,

DPS = Dividends per share, for next year

CMV = Current market value of stock

GRD = Growth rate of dividends

Depending on the parties involved, there are two distinct ideas

referred to as the “cost of equity.” The needed rate of return on an
equity investment, if you are the investor, is known as the cost of
equity. If you are a business, the needed rate of return on a certain
project or investment is determined by the cost of equity.

S
A business may raise cash using either debt or equity. Debt is less
expensive, but the corporation has to repay it. Although equity does
IM
not need repayment, it often costs more than borrowed capital since
interest payments are tax deductible. Stock often offers a better rate
of return than debt since the cost of equity is higher.

SELF ASSESSMENT QUESTIONS

M

12. The return a business needs to determine if an investment

satisfies capital return criteria is known as
a. Cost of debt
b. Cost of capital
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c. Cost of equity
d. None of these
13. Which of the following often offers a better rate of return than
debt since the cost of equity is higher?
a. Warrants
b. Stock
c. Derivatives
d. Options

ACTIVITY

Find some advantages of the Cost of Equity.

 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 177

5.9 COMPUTING THE WACC, THREE CASES

We calculate the WACC for Merck, Whole Foods and Caterpillar in
the sections that follow. For each of these scenarios, we choose E (rM)
= 8.45% and rF = 0.06%, which is the rate on 3-month Treasury bills.
These three instances—for Merck, Whole Foods and Caterpillar—
illustrate various scenarios as well as how necessary the WACC cal-
culations are.

5.9.1 COMPUTING THE WACC FOR MERCK (MRK)

In earlier parts, we spoke about Merck’s cost of equity rE and cost of

debt rD. These calculations are summarised in Figure 5.31:

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Figure 5.31: Computation of WACC for Merck

The predicted WACC for Merck (cell B32) contains a decision: We

averaged the three estimates that were the closest in value, excluding
the one estimate that seemed excessive to us.

5.9.2 COMPUTING THE WACC FOR WHOLE FOODS MARKET

(WFM)

Earlier, we used Whole Foods Market (WFM) as an example of a cor-

poration with negative net debt since it has more liquid assets than
debt.
178 FINANCIAL MODELLING

Dividend payments from the corporation have decreased over the last
five years, with a pause between July 2008 and January 2011 as shown
in Figure 5.32:

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Figure 5.32: Computation of WFM r E with the Golden Model

The average of the two dividend growth rates in B9 and B10 is used in
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the WACC template after this paragraph.

The business has absorbed stock from the capital markets during the
last three years, according to Whole Foods’ total equity distributions.
We do not believe that the total equity distributions have any growth
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rate that can be included in the WACC calculation.

For WFM, we disregard this approach when calculating the cost of

equity in Figures 5.33 and 5.34:

Figure 5.33: Calculation of Equity Pay-outs with Golden Model

 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 179

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Figure 5.34: Calculation of WACC for WFM

5.9.3 COMPUTING THE WACC FOR CATERPILLAR (CAT)

Caterpillar’s cost of debt is very low as shown in Figure 5.35:

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Figure 5.35: Calculation of WACC for Caterpillar (CAT)

When Caterpillar earns a lot of money, its tax rate is comfortably

around 25% as shown in Figure 5.36:

Figure 5.36: Calculation of Caterpillar Tax Rate

180 FINANCIAL MODELLING

The last ten years of CAT’s dividend history are shown here. In
our approach, we will use the Gordon dividend model to determine
CAT’s rE using the past five years of annual dividend growth as shown
in Figure 5.37:

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Figure 5.37: Caterpillar Dividend Growth and Golden Dividend

Equity distributions at Caterpillar are very erratic. We base the pay-

ment method of determining rE on the growth over the previous two
years as shown in Figure 5.38:

Figure 5.38: Calculation of Caterpillar’s Equity Pay-outs

 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 181

We get the following template for CAT’s WACC using these values as
shown in Figure 5.39:

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Figure 5.39: Calculation of WACC for Caterpillar (CAT)
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Our WACC estimates are divided into two categories: those produced
by the two Gordon-based models and those by the two CAPM-based
techniques. Here, we average the results of the two most recent cal-
culations (our general preference is often for CAPM over the dividend
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models).

SELF ASSESSMENT QUESTIONS

14. Which of the following model is used to determine CAT’s rE

using the past five years of annual dividend growth?
a. Caterpillar (CAT)
b. Weighted Average Cost of Capital
c. Both a. and b.
d. None of these

ACTIVITY

How WACC is useful for any firm? Discuss

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184 FINANCIAL MODELLING

c. Cost of debt
d. Both a. and c.
5. Which of the following refers to how it uses various funding
sources, including debt such as bonds or loans, to support its
overall operations and growth?
a. Cost of debt
b. Cost of capital
c. Cost of equity
d. Capital structure
6. WACC is used in financial modelling as which rate to determine
a business’s net present value?
a. Discount rate
b. Interest rate

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c. Yield rate
d. Bond rate
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7. Weighted Average Cost of Capital is a crucial component of which
of these?
a. Initial Public Offering (IPO) model
b. Leveraged Buyout (LBO) model
c. Discounted Cash Flow (DCF) valuation model
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d. All of these
8. Which of these is known as the returns that may be obtained
by investing in an asset that carries no risk, such as the U.S.
Treasury bonds?
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a. Risk-free rate of return

b. Cost of capital
c. Weighted average rate of return
d. Market return
9. Which of the following is the additional yield that may be obtained
by investing in the stock market above the risk-free rate?
a. Levered beta
b. Equity Risk Premium (ERP)
c. Risk-free rate of return
d. Weighted average rate of return
10. The company’s issuing of shares represents a significant:
a. Positive cash flow to equity
b. Negative cash flow to equity
 WEIGHTED AVERAGE COST OF CAPITAL (WACC) 185

c. Discounted cash flow to equity

d. Future cash flow to equity

5.12 DESCRIPTIVE QUESTIONS

1. Explain the Weighted Average Cost of Capital (WACC). ?
2. Discuss the computation of the value of the firm.
3. Describe the cost of equity.

HIGHER ORDER THINKING SKILLS

5.13
(HOTS) QUESTIONS
1. Which method of calculating the cost of capital comprises
dividing the dividend by the market price or net proceeds per
share?
a. Adjusted price method
b. Price earning method
c. Dividend yield method
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d. Adjusted dividend method
2. In Weighted Average Cost of Capital, an organisation can affect
its cost of capital through _________.
a. The policy of investment
b. The policy of capital structure
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c. The policy of dividends

d. All of these
3. ____________ is the rate of return that a corporation will forfeit by
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choosing any other project over the most attractive investment

opportunity.
a. Implicit cost
b. Specific cost
c. Explicit cost
d. None of these

5.14 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Weighted Average Cost of 1. a. Required rate of return
Capital (WACC)
186 FINANCIAL MODELLING

Topic Q. No. Answer

2. b. Weighted Average Cost of
Capital (WACC)
Using the CAPM to Estimate 3. b. Capital asset pricing model
the Cost of Equity
4. b. Free Cash Flow (FCF)
5. b. Opportunity cost
6. a. Levered beta
Computing the Value of the 7. c. Market value
Firm’s Equity, E
8. b. Liquid assets
Two Approaches to Comput- 9. a. Current dividend
ing the Firm’s Cost of Equity,
rE

Model for rE
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Implementing the Gordon 10. a. Dividend growth
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The CAPM: Computing the 11. d. Risk-adjusted cost of capital
Beta, β
Cost of Equity, Ke / Ri 12. c. Cost of equity
13. b. Stock
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Computing the WACC, Three 14. a. Caterpillar (CAT)

Cases

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

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Q. No. Answer
1. c. Merger
2. d. All of these
3. a. Cost of capital
4. c. Cost of debt
5. d. Capital structure
6. a. Discount rate
7. c. Discounted Cash Flow (DCF) valuation model
8. a. Risk-free rate of return
9. b. Equity Risk Premium (ERP)
10. b. Negative cash flow to equity
 C H A
6 P T E R

BUILDING AN INTEGRATED CASH FLOW MODEL

CONTENTS

6.1 Introduction
6.2
6.2.1
6.2.2 S
Building an Integrated Cash Flow Model
Use Automation to Improve Your Forecasting Model’s Reliability
Summary: How to Create a Cash Flow Forecast in Excel
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Self Assessment Questions
Activity
6.3 Understanding Circularity
6.3.1 An alternative approach to solving circular interest
6.3.2 Using algebra to solve circular interest
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Self Assessment Questions

Activity
6.4 Setting up and Formatting the Model
6.4.1 A Consistent Colour Scheme
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6.4.2 Exact Figures in Financial Model Formatting

6.4.3 Text with Custom Formatting
6.4.4 Financial Model Formatting Matters
Self Assessment Questions
Activity
6.5 Selecting Model Drivers and Assumptions
6.5.1 Model Tab: Detailed Calculations and Operating Build-up
Self Assessment Questions
Activity
6.6 Creating the Debt and Interest Schedule
Self Assessment Questions
Activity
6.7 Free Cash Flow (FCF): Measuring the Cash Produced by the Business
Self Assessment Questions
Activity
190 FINANCIAL MODELLING

CONTENTS

6.8 Merck: Reverse Engineering the Market Value

Self Assessment Questions
Activity
6.9 Summary
6.10 Multiple Choice Questions
6.11 Descriptive Questions
6.12 Higher Order Thinking Skills (HOTS) Questions
6.13 Answers and Hints
6.14 Suggested Readings & References

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 BUILDING AN INTEGRATED CASH FLOW MODEL 191

INTRODUCTORY CASELET

CASH FLOW

In conjunction with the other financial statements, the cash flow

statement offers data that enables users to assess changes in an Case Objective
organisation’s net assets, its financial structure (including its
This caselet highlights the
liquidity and solvency) and its capacity to control the amounts overview of cash flow.
and timing of cash flows to respond to new situations and oppor-
tunities. The ability of an organisation to produce cash and cash
equivalents may be evaluated using cash flow statistics. Users can
also create models to evaluate and compare the present value of
the future cash flows of other firms. Because it eliminates the con-
sequences of applying various accounting procedures to the same
transactions and events, it also improves the comparability of the
reporting of operating performance by various firms.

The quantity, timing and predictability of future cash flows are

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frequently predicted using data on historical cash flows. Addition-
ally, it helps analyse the reliability of previous forecasts of future
cash flows, the link between profitability and net cash flow and
the effects of fluctuating pricing.
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An organisation displays the cash flows from operating, investing
and financing operations in the way that is best suitable for its
industry. Users may evaluate the effects of different activities on
the enterprise’s financial condition and the quantity of cash and
cash equivalents by looking at data that is categorised by activity.
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The linkages between such actions can also be evaluated using

this information.
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192 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

> Define the meaning of cash flow
> Explain the building of an integrated cash flow model
> Discuss the circularity
> Describe the setting up and formatting of the model
> Analyse the selecting model drivers and assumptions
> Summarise the creation of the debt and interest schedule

6.1 INTRODUCTION
Quick Revision In the previous chapter, you have studied the Weighted Average Cost
of Capital (WACC). A business organisation collates finance from its
investors (both equity and debt investors) and utilises those funds to

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generate returns. These investors are, thus, assuming a risk by enforc-
ing trust that the organisation will spend their financial resources
prudently. Subsequently, investors require a return to compensate
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for owing the risk. This is what we infer as the “investors’ required
return” or we can say that the shareholders’ position is the sharehold-
ers’ required return.

Information regarding the cash flows of an organisation is beneficial in

offering users of financial statements with useful information to gauge
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the calibre of the organisation to generate cash and cash equivalents

and the needs of the organisation to make use of those cash flows.

The economic decisions that are initiated by decision makers man-

date an evaluation of the ability of an organisation to generate cash
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and cash equivalents along with appropriate timing and certainty of

their generation.

The Cash Flow Model revolves around the provision of information

about the historical changes in cash and cash equivalents of an organ-
isation through the transferring of a cash flow statement which cate-
gorises cash flows during the timeline from operating, investing and
financing activities. Users of an organisation’s monetary statements
are willing to delve into how the organisation generates cash and cash
equivalents and how it is being utilised.
NOTE Organisations require financial resources for many reasons, how-
A cash flow model is a thorough ever, their key revenue-producing model might be different. Business
representation of a client’s enterprises require cash to run day-to-day business operations, fulfil
assets, investments, liabilities, financial obligations and provide returns to their investors.
income and outlays that is
projected ahead, year by year,
In this chapter, building an integrated cash flow model, understand-
utilising estimated rates of
growth, income, inflation, pay ing circularity, setting up and formatting the model, selecting model
increases and interest rates. drivers and assumptions, creating the debt and interest schedule,
 Know More
The operational cash flows
that remain after capital
expenditures, which represent
the expenses of sustaining
the asset base, are used as
the basis for the valuation
technique. To evaluate the entire
company, this cash flow is taken
into account before interest
payments to debt holders.
NOTE
A form of model that predicts a
company’s income statement,
balance sheet, and cash flow
statement is known as an
integrated 3-statement financial
model.
 BUILDING AN INTEGRATED CASH FLOW MODEL 195

Figure 6.2 shows an illustration of a weekly cash prediction,

where each column forecasts cash levels for a particular week: Know More
Three-statement financial
models can be built in a variety
of different layouts and designs.

Figure 6.2: Forecasts Cash Levels for A Particular Week

A 13-week Cash Flow Forecast is the most popular weekly fore-

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casting model because it offers both a decent level of accuracy
and a constant, quarterly perspective of impending cash flows.
For forecasting one to four months out, weekly forecasting pe-
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riods work well.
iii. Monthly reporting: Cash flow roles are categorised monthly
by monthly reporting. A logical extension of budgeting
procedures, monthly forecasting periods are excellent for
longer-term planning objectives. In Figure 6.3, cash flows for
several months are shown in each column of a monthly cash
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forecast:
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Figure 6.3: Cash Flows for Several Months

NOTE
The number of forecast periods
is constant for a rolling monthly
cash flow projection (for
example, 12 months and 18
months). Every time there is a
month of previous data to enter,
the prediction gets advanced.
 BUILDING AN INTEGRATED CASH FLOW MODEL 197

at the outset. In addition, it demonstrated how to utilise the terminal

value to compute expected returns on stock investments. NOTE
Estimating your upcoming
The procedure for creating the Excel Cash Flow Forecast that was revenues and costs is part
utilised in this summary is listed as follows: of the cash flow forecasting
process. A cash flow prediction
1. Make a spreadsheet containing the company plan’s key drivers. is an essential tool for your
Don’t forget to include a remark column outlining the reasoning company since it will let you
know whether you will have
behind each premise. enough money to run or grow
the enterprise.
2. On a different Excel page, create a monthly cash flow forecast.
Connect estimates to the revenue and expense assumptions.
3. For calculations, use simple Excel formulae. Use formulae such
as SUM, IF, SUMIFS and COUNTIF to learn.
4. Put cash flow projections into a quarterly or yearly perspective.
To help understand forecasting patterns, provide graphics.

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5. Estimate the amount of equity needed to finance the model.
Describe the cost categories in detail to show how the investment
will finance the strategy.
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6. Using forecasts, calculate the enterprise and exit values.
Calculating the returns on investment requires discounting the
cash flows.
7. Include important financial metrics such as NPV, IRR or cash
flow break-even points. To assess the feasibility of prediction,
compute margins.
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8. Utilising the Assumptions sheet, construct scenarios and test

the cash flow model. To determine the model’s breaking points,
subject it to stress testing.
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9. Include the balance sheet, P&L and cash flow statements. The
Excel sheets are linked together so that changes made to one
influence the results of the other.
10. Examine the effect that debt calculations will have on the cash
flow forecast. Note the modifications to the investment return
criteria and the equity requirement.

SELF ASSESSMENT QUESTIONS

1. Which of the following is created for the business plan’s

assumptions, and add a remark column?
a. Excel page
b. Word page
c. Data table
d. None of these
 DID YOU KNOW
You want to make sure there are
no circular references in the
file. Go to tab ‘Formulas’, choose
‘Error-checking’ and ‘Circular
References’. Excel will show you
exactly in which cell(s) circular
references are detected.
 Know More
Some financial models might
include only a profit-and-loss
statement, some might include
simply a cash flow statement,
but many include all three. If a
financial model does contain all
three, you might hear it referred
as a three-way financial model.
 Know More
The purpose of a 3-statement
model (i.e. an integrated
financial statement model) is to
forecast or project the financial
position of a company as a
whole.

` `
NOTE
A cash flow model is a
comprehensive representation
of a client’s assets, investments,
liabilities, income, and outlays
that is projected forward, year
by year, utilising estimated rates
of growth, income, inflation, pay
increases and interest rates.
202 FINANCIAL MODELLING

The underscore (_) is used to align decimals for positive and negative
integers in a column by creating a gap in the size of the following char-
acters.

Example

POSITIVE SPACE ADDER NEGATIVE

0.1% _ (0.0%)

6.4.3 TEXT WITH CUSTOM FORMATTING

Whether working with multiples, basis points or years, it is typical to

see letters or words following a number. These will be interpreted by
Excel as “numbers” rather than “text.” For instance, if we wrote the
number 3.4 as #, ##0.0x, it would appear as 3.4x and if we typed 150
as 0 “bps,” it would appear as 150 bps.

6.4.4
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FINANCIAL MODEL FORMATTING MATTERS

Quality analytical work and excellent presentation are both crucial for
a variety of reasons, therefore, formatting is crucial. The owner and
IM
the company are represented by their work, to start with. Additionally,
unprofessional work might convey a false idea about the quality of the
task. Finally, even if the figures are entirely true, a poor presentation
could cost you a sale.

SELF ASSESSMENT QUESTIONS

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4. On the same schedule or page, this colour should be utilised

for computations and references (C4). Which of the following
option is correct regarding the above statement?
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a. Red
b. Dark red
c. Green
d. Black
5. Which of the following colour is preferred for usage with
historical, underlying assumptions and driving factors as
inputs (172.551 or = 258.849 + 9.988 – 2.624)?
a. Green
b. Blue
c. Black
d. Dark red

ACTIVITY

Find the method of formatting the model.

 BUILDING AN INTEGRATED CASH FLOW MODEL 203

SELECTING MODEL DRIVERS AND

6.5
ASSUMPTIONS
The drivers (inputs) tab must appear right after the model’s cover
page. Given that non-finance operators are likely to use this tab the
most, you must make sure it is clear, succinct and simple to grasp. The
inputs tab should have two input sections, one for static inputs and
the other for dynamic inputs. Dynamic inputs are those that fluctuate
over time (for example, from month to month or year to year), such as
“inflation” assumptions, “cost of debt,” or “revenue growth” assump-
tions. Examples of static inputs are hypothetical “size of a power
plant” or “a company’s initial debt amount” as shown in Figure 6.5:

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When building a model, you
will generally be faced with a
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number of considerations about

how exactly to build it.

Figure 6.5: Sample Drivers and Assumptions Tab

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Source: [Link]

This data is classified into two categories within both of the aforemen-
tioned static vs. dynamic input sections: (1) hard-coded figures that
remain the same regardless of the assumptions scenario, and (b) sen-
sitising parameters that will drive various assumptions scenarios and,
ultimately, sensitivity tables. But keep in mind that until the project is
finished, it will not completely know which parameters will be sensi-
tive and which will not.

6.5.1 MODEL TAB: DETAILED CALCULATIONS AND

OPERATING BUILD-UP

This tab serves as the model’s central hub, bringing together all of
the inputs, hypotheses and scenarios to forecast a company’s financial
success over the next years. This tab will also be used to run multiple
assumption-driven scenarios and to complete the valuation portion of
204 FINANCIAL MODELLING

the exercise before making the ultimate strategic choice as shown in

Figure 6.6:

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Figure 6.6: Sample Model Tab

Source: [Link]

SELF ASSESSMENT QUESTIONS

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6. Which of the following tab must appear right after the model’s
cover page?
a. Assumptions b. Drivers (inputs)
c. Both a. and b. d. None of these
7. Which of the following remains the same regardless of the
assumptions scenario?
a. Hard-coded figures b. Sensitising parameters
c. Sensitivity tables d. All of these

ACTIVITY

Discuss with your friends the uses of model drivers.

 Know More
A debt schedule lists every debt
that a company has according
to its maturity on a timetable.
Businesses often utilise it to
create a cash flow analysis. The
following diagram illustrates
how principle repayments move
via the cash flow statement, the
closing debt balance flows into
the balance sheet, and interest
cost from the debt schedule
flows into the income statement.
206 FINANCIAL MODELLING

The aforementioned elements make it possible to monitor the debt

till maturity. The interest cost goes to the income statement, while the
closing amount from the schedule flows back to the balance sheet.

AMORTISATION SCHEDULE

Amortisation schedule refers to the loans that amortise have constant

payment amounts throughout the course of the loan, but the compo-
nents of each payment—interest and principle—variate. An ordinary
mortgage is one of these loans.

The full table of periodic loan payments, including the amounts of

principal and interest that make up each level payment until the loan
is repaid in full after its term, is represented by a loan amortisation
schedule. The bulk of each payment is used to pay interest at the
beginning of the schedule, as time goes on, the majority of payments
start to cover the loan’s remaining principal.
NOTE
Based on your loan and your
needs, you may create your own
amortisation schedule. You may
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The lender should provide a copy of the loan amortisation schedule if
an individual taking out a mortgage or vehicle loan so it can quickly
determine how much the loan will cost and how the principal and
interest will be divided throughout its term.
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evaluate how making expedited
payments will speed up your
amortisation using more complex
According to a loan amortisation plan, the amount of each payment
amortisation calculators, such that is allocated to interest decreases somewhat with each payment,
as the Excel templates. while the amount allocated to the principal rises.

A 30-year fixed-rate mortgage for `1,65,000 with a 4.5% interest rate is

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shown in Figure 6.8:

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Figure 6.8: The Loan Amortisation Schedule

 BUILDING AN INTEGRATED CASH FLOW MODEL 207

Based on loan and needs, create an amortisation plan. Evaluate how

making expedited payments will speed up amortisation using more
complex amortisation calculators, such as Excel templates. These
tools are used to analyse how paying down the debt with a windfall
might change the loan’s maturity date and the amount of interest paid
throughout the loan, for instance, if it is anticipating an inheritance or
getting a certain annual bonus.

Along with mortgages, vehicle loans and personal loans also amor-
tise over a certain time with a fixed interest rate and a predetermined
monthly payment. The conditions change based on the asset. Most
traditional mortgages have terms of 15 or 30 years. Car owners often
take for a car loan with a five-year maximum repayment period.
3 years is a typical repayment period for personal loans.

FORMULAS USED IN AMORTISATION SCHEDULES

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Borrowers and lenders use amortisation schedules for installment
loans with predetermined payment dates at the time the loan is
arranged, such as a mortgage or a car loan. Exact calculations are used
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to produce a loan amortisation schedule. A software could already
include these calculations or it might need to start from scratch when
creating an amortisation plan.

There is a simple method to determine a loan amortisation plan with-

out using an online amortisation schedule or calculator if it is know
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the loan term and the total amount of monthly payments. An amor-
tised loan’s monthly principle payment is determined using the fol-
lowing formula:
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Principal Payment = Total Monthly Payment – [Outstanding Loan

Balance × (Interest Rate / 12 Months)]

Let’s use an example where a loan has a 30-year term, a 4.5% inter- Know More
est rate and an ` 1,266.71 monthly payment. Multiply the loan sum According to a loan amortisation
(` 250,000) by the recurring interest rate beginning in month one. plan, the amount of each
payment that is allocated to
The final equation is ` 250,000 × 0.00375 = ` 937.50 since the periodic
interest decreases somewhat
interest rate is one-twelfth of 4.5% (or 0.00375). The result is the inter- with each payment, while the
est payment for the first month. Calculate the part of the loan payment amount allocated to principle
allotted to the principal of the loan debt (` 329.21) by deducting that rises.
sum from the monthly payment (` 1,266.71 – ` 937.50).

Subtract the principal payment made in month one (` 329.21) from the
loan total (` 250,000) to get the new loan balance (` 249,670.79). Next,
use the same procedures as before to determine how much of the sec-
ond payment will go toward interest and how much toward principal.
Until you have a timetable for the loan’s whole life and keep going
through these procedures.
208 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

8. Which of the following lists every debt that a company has

according to its maturity on a timetable?
a. Amortisation schedule b. Debt schedule
c. Both a. and b. d. None of these
9. Identify the items included in the debt schedule.
a. Opening balance (beginning of the period)
b. Repayments (decreases)
c. Draws (increases)
d. All of these

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ACTIVITY

Find the advantages and disadvantages of the Debt Schedule.

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FREE CASH FLOW (FCF): MEASURING
6.7 THE CASH PRODUCED BY THE
BUSINESS
Free Cash Flow is the amount of money a company has left over after
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paying for operational costs and capital asset maintenance. In con-

trast to profits or net income, free cash flow is a measure of profitabil-
ity that accounts for both changes in working capital from the balance
sheet as well as spending on assets and machinery. The income state-
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ment is also cleared of non-cash elements.

Interest payments are not included in the widely accepted definition

of free cash flow. Investment bankers and analysts will evaluate a
company’s expected performance under alternative capital structures
using free cash flow variations, such as free cash flow for the business
and free cash flow to equity, which are adjusted for interest payments
and borrowings.

To measure the impact of dilution, free cash flow is often calculated on

a per-share basis.

The cash flow that a firm has available to pay dividends and inter-
est to investors, as well as its creditors, is known as Free Cash Flow
NOTE (FCF). Because these measurements exclude non-cash items from
Free cash flow = sales revenue the income statement, some investors prefer to use FCF or FCF per
- (operating costs + taxes) share as a measure of profitability over profits or earnings per share.
- required investments in FCF may be lumpy and uneven over time, however, since it takes into
operating capital. account investments in real estate, machinery and equipment.
 BUILDING AN INTEGRATED CASH FLOW MODEL 209

BENEFITS OF FCF

FCF may provide significant insights into the value of a firm and the
health of its basic trends since it considers working capital movements.
A decline in accounts payable (outflow) might indicate that suppliers
want payments made more quickly. A decline in accounts receivable
(inflow) might indicate that consumers are paying the business more
quickly. A growing backlog of unsold goods may be indicated by a rise
in inventory (outflow). Working capital inclusion adds a dimension to
profitability metrics that the income statement neglects.

Assume, for example, that a business has earned ` 50,000,000 in net

profits every year for the previous ten years. On the surface, it seems
Know More
Free cash flow is important to
consistent, but what if FCF has been declining over the previous two investors and business analysts
years as stocks increased (outflow), consumers started delaying pay- because it shows how much
ments (outflow) and suppliers started requesting quicker payments cash your company has at its
from the company (outflow)? In this case, FCF would disclose a signif- disposal. They often assess your
free cash flow to determine

the income statement.

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icant financial vulnerability that was not apparent by just looking at

FCF is a good place for potential investors or lenders to start when

whether your company has
enough cash to repay debts,
issue dividends and buy back
shares.
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determining whether the company will be able to cover its expected
dividends or interest. If the company’s loan payments were deducted
from FCF, the quality of cash flows available for future borrowings
would be better understood by lenders (free cash flow to the business).
Similar to this, by deducting interest expenses from FCF, investors
may assess the expected consistency of future dividend payments.
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LIMITATIONS OF FCF

Consider a business with `1,000,000 in profits before interest, taxes,

depreciation and amortisation (EBITDA) each year. Assume further
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that this company’s working capital (current assets minus current lia-
bilities) has not changed, but that at year’s end, `8,00,000 worth of new
equipment was purchased. Depreciation on the income statement will
be used to stretch out the cost of the new equipment over time, bal-
ancing the effect on profits.

The corporation will report `2,00,000 FCF (`10,00,000 EBITDA –

`8,00,000 equipment) on `10,00,000 of EBITDA that year, however,
since FCF takes into account the cash spent on new equipment in
the current year. EBITDA and FCF will be identical once again the
next year, assuming nothing else changes and no new equipment is
purchased. In this case, a potential investor must decide why FCF
dropped so sharply one year before rising again and if the trend is
likely to persist.

Further insights may be gained by comprehending the depreciation

mechanism being used. For instance, dependent on the amount of
depreciation taken each year of the asset’s useful life, net income and
210 FINANCIAL MODELLING

FCF will vary. If the asset is being depreciated over a useful life of 10
years using the book depreciation method, then net income will be
`80,000 (`800,000/10 years) less than FCF for each year until the asset
is fully depreciated. On the other hand, if the asset is being depreci-
ated according to the tax depreciation method, the asset will be com-
pletely depreciated in the year it was acquired, resulting in net income
that equals FCF in later years.

CALCULATING FCF

Starting with the cash flows from operating activities on the state-
ment of cash flows, FCF may be determined since this figure will
already contain profits that have been adjusted for non-cash items
and changes in working capital.

Factor Location
+ Cash flow from operating activity Statement of Cash Flow

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- Interest Expenses
- Tax Shield on Interest Expenses
- Capital Expenditures (CAPEX)
Income Statement
Income Statement
Statement of Cash Flow (Cash Flow
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from Investing Activities)
= Free Cash Flow

FCF may also be calculated using the balance sheet and income state-
ment.
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Factor Location
+ EBIT × (1- Tax Rate) Income Statement
+ Non-cash Expenses (Deprecation, Income Statement
Amortisation, etc.)
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- Change in (Current Assets- Cur- Balance Sheet (current period and

rent Liabilities) previous period)
- Capital Expenditures (CAPEX) Balance Sheet: Property, Plant and
Equipment (Current period and
previous period)
= Free Cash Flow

The same computation may be made using additional data from the
cash flow statement, balance sheet and income statement. An investor
might determine the right computation, for instance, if EBIT was not
provided.

Factor Location
+ Net Income Income Statement
+ Interest Expenses Income Statement
- Tax Shield on Interest Expenses Income Statement (Net Interest
expenses × Tax rate)
 BUILDING AN INTEGRATED CASH FLOW MODEL 211

Factor Location
+ Non-Cash expenses (Deprecia- Income Statement
tion, Amortisation, etc.)
- Change in (Current Assets- Cur- Balance Sheet (current period and
rent Liabilities) previous period)
- Capital Expenditures (CAPEX) Balance Sheet: Property, Plant and
Equipment (Current period and
previous period)
= Free Cash Flow

FCF is not required to give the same financial disclosures as other line
items in the financial statements, though. This is problematic because,
if you take into consideration the possibility that capital expenditures
(Capex) may cause the number to appear a little “lumpy,” FCF is a
valuable tool for verifying a company’s declared profitability. Even
while the effort is important, not all investors possess the required
background knowledge or have the time to dedicate to manually cal-
culating the number.

SELF ASSESSMENT QUESTIONS S

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10. The cash a firm earns after deducting cash expenditures for
operating expenses and capital asset maintenance is known
as
a. Discounted cash flow b. Balance sheet
c. Free cash flow
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d. Income statement
11. The commonly recognised notion of free cash flow excludes
a. Interest received b. Principal payment
c. Cash received d. Interest payments
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ACTIVITY

Discuss the process of Free Cash Flow.

MERCK: REVERSE ENGINEERING THE

6.8
MARKET VALUE
The discounted cash flow (DCF) analysis is a stock valuation method
that may have come across if it is ever thumbed through a stock ana-
lyst’s report. To calculate DCF, a firm must anticipate its future cash
flows, apply a discount rate based on the risk it faces and determine a
precise value for its shares, sometimes known as a “target price.”

The issue is that forecasting future cash flows involves a fair amount
of speculation. There is a solution to this issue, however. It can deter-
mine the amount of cash flow that the firm would need to create to
S
214 FINANCIAL MODELLING

6.10 MULTIPLE CHOICE QUESTIONS

MCQ
1. When building a financial model, everything from colours to
figures to formulae to text has a precise
a. Formatting rationale
b. Colour scheme
c. Custom formatting
d. Circular logic
2. Which of the following is a symbol for caution and should be used
to alert other users or link to another model (= [TTS v1.0xls]
Sheet1! C3)?
a. Red
b. Green
c. Blue
d. Black
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3. For a formula connecting to databases such as Capital IQ (=CIQ
($E$2, “IQ TOTAL REV”, IQ FY)), a deep, dark crimson is
acceptable. Which of the following option is correct regarding
the above statement?
a. Black
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b. Green
c. Dark red
d. None of these
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4. Which of the following colour should be used to illustrate

references to other schedules or sheets (=Sheet1! B3)?
a. Black
b. Green
c. Yellow
d. Red
5. Which of the following will drive various assumptions scenarios
and, ultimately, sensitivity tables?
a. Assumptions
b. Inputs
c. Hard-coded figures
d. Sensitising parameters
 BUILDING AN INTEGRATED CASH FLOW MODEL 215

6. The full table of periodic loan payments, including the amounts

of principal and interest that make up each level payment until
the loan is repaid in full after its term, is represented by
a. Amortisation schedule
b. Debt schedule
c. Both a. and b.
d. None of these
7. Which of the following should provide a copy of the loan
amortisation schedule if an individual taking out a mortgage or
vehicle loan?
a. Owner
b. Lender
c. Lessee
d. All of these

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8. A decline in which of the following might indicate that suppliers
want payments made more quickly?
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a. Accounts receivable
b. Accounts payable
c. Inventory
d. Cash
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6.11 DESCRIPTIVE QUESTIONS ?

1. Define the circularity.
2. Discuss the debt schedule and amortisation schedule.
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3. Explain the Free Cash Flow (FCF).

HIGHER ORDER THINKING SKILLS

6.12
(HOTS) QUESTIONS
1. A decline in which of the following might indicate that consumers
are paying the business more quickly?
a. Accounts receivable
b. Accounts payable
c. Inventory
d. Cash
2. Which of the following inclusion adds a dimension to profitability
metrics that the income statement neglects?
a. Fixed assets
b. Current assets
216 FINANCIAL MODELLING

c. Working capital
d. None of these

6.13 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Building an Integrated Cash 1. a. Excel page
Flow Model
2. b. Revenues
Understanding Circularity 3. c. Circular reference
Setting up and Formatting 4. d. Black
the Model
5. b. Blue

Assumptions
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Selecting Model Drivers and 6.

7.
b.

a.
Drivers (inputs)

Hard-coded figures
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Creating the Debt and Inter- 8. b. Debt schedule
est Schedule
9. d. All of these
Free Cash Flow (FCF): Meas- 10. c. Free Cash Flow
uring the Cash Produced by
the Business
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11. d. Interest Payments

Merck: Reverse Engineering 12. a. Discounted Cash Flow
the Market Value (DCF)
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ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. a. Formatting rationale
2. a. Red
3. c. Dark red
4. b. Green
5. d. Sensitising parameters
6. a. Amortisation schedule
7. b. Lender
8. b. Accounts payable

HINTS FOR DESCRIPTIVE QUESTIONS

1. When a formula depends either directly or indirectly on itself,
a circular reference is produced. When C=A+B, yet A or B is a
function of C in turn, this is known as circular logic.
 CASE STUDIES
4 TO 6

CONTENTS

Case Study 4 Sensitivity Analysis in Excel

Case Study 5 Weighted Average Cost of Capital
Case Study 6 Assessment of Cash flow

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220 FINANCIAL MODELLING

CASE STUDY 4

SENSITIVITY ANALYSIS IN EXCEL

Joe Nicolas is an analyst and he in the case of bond pricing identi-

Case Objective fied the coupon rate and the yield to maturity as the independent
The aim of this case study is variables. He mentioned that the dependent output formula is the
to discuss the relevance and bond price. The coupon is paid in 6 months with a 1,000-dollar par
uses of sensitivity analysis. value. It is expected that the bond will expire in 5 years.

Joe evaluated the sensitivity of the bond price for multiple values
of coupon rate and yield to maturity. Let us understand how he
performed the sensitivity analysis.

Joe took the coupon rate range as (Refer to Table A):

Table A: Range of Coupon Rate and Coupon Rate

Range of coupon rate (%) Coupon rate (%)
5.00 5

S5.50
6.00
6.50
6
7
8
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7.00 9

Joe, based on the technique, considered all the combinations of

yield to maturity and coupon rate for calculating the bond price
sensitivity.
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Now, let us see how he performed the calculation of the bond

price. Below given table shows the bond price:

The Bond Price is $102,160

222 FINANCIAL MODELLING

CASE STUDY 5

WEIGHTED AVERAGE COST OF CAPITAL

Mr. Aman is working as a financial analyst in the ABC Corpora-

Case Objective tion. Mr. Aman has several responsibilities out of which one is to
This case study exhibits about make sure that overall cost of capital of the corporation should be
calculating overall Weighted minimum without affecting the quality of return. For achieving
Average Cost of Capital. the same objectives Mr. Aman prepares a certain portfolio where
proportion of debt, equity and preferred stocks are arranged ins
such a manner that they do not increase the borrowing cost and
simultaneously help in providing better return.

Given that ABC Corporation is operating under the category of

perfect competition market. So, ABC Corporation also requires
ensuring that the proportion of their debt and equity should be
equitable.

Suppose that the cost of common stock equity of ABC Corpora-

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tions is 8.4%. The cost of preferred stock equity is 6.8% and the
weighted average interest rate on the company debt is 6.9%. Also,
assume that the market value percentage of each component of
the capital structure are 55% common stock, 20% and 25% debt.
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The corporate tax rate is 30%.

QUESTIONS

1. Find out the after-tax cost of debt?

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(Hint: Cost of debt (after tax) = Interest rate × (1-tax rate)

= 6.0 % × (1-0.3)
= 4.2% or 0.042
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2. Compute Weighted Average Cost of Capital (WACC)?

(Hint: WACC = {(proportion of equity / Value of firm ×
cost of equity) + proportion of preferred stock / value
of firm × cost of preferred stock) + (proportion of debt/
Value of firm × Cost of debt (after tax)}
= (8.4% × 55%) + (6.8% × 20%) + (4.2% × 25%)
= 7.03%
 CASE STUDY 6: ASSESSMENT OF CASH FLOW 223

CASE STUDY 6

ASSESSMENT OF CASH FLOW

In 2016, Mr. Rahul started a job, working as a driver with Mr. Abdul
Khan of M/s Khan and Sons. However, in April 2017, he decided to Case Objective
run his own business of operating and maintaining cabs. For this pur- This case study underscores
pose, he acquired a car costing `8,20,000. This payment comprised cash flow in the business.
` 40,000 on annual insurance, `70,000 on 15-year road tax and
`4,500 on expenses related to legal registration. Mr. Rahul paid
`2,15,000 as the down payment and undertook a mortgage loan
for the payment of the remaining balance. This mortgage loan
was structured in such a manner that it had 36 monthly instal-
ments of `19,000 each.

During the first year of commencement of the cab business, his

only source of income was the fare money collected from the cab
service, which amounted to ` 2,28,000.

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He had noted down all the detailed information of expenditure
incurred by him in a pocket diary as given in Table A:

Particulars Amount (in `)

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Groceries purchased for personal use 59,255
Clothes bought for himself and his family 3,590
Tuition fees for his son 900
Driver’s uniform for himself and the driver’s badge 3,155
Refreshments while on duty 19,000
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Sari bought it for his mother 1,300

Diesel and oil 1,89,500
Electricity bill payment for his house 12,000
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Loan EMI paid 2,20,000

Deposited in a savings bank account 8,160

He organised a small get-together party for his family and friends.

His wife was concerned that he had invested all his savings in the
cab business and did not save anything therefrom. His wife asked
him, “Did you make any profit?” After recalling his expenses and
making some mental computations, he replied, “As of now, I have
made a loss of `2,88,860.”

To take a second opinion, his wife insisted he consult her cousin,

Mrs. Divyanka Seth, who is a practising Chartered Accountant.
Mrs. Divyanka told her that the books of accounts need to be pre-
pared taking into consideration accounting concepts and basic
principles.
224 FINANCIAL MODELLING

CASE STUDY 6

QUESTIONS

1. Do you think that Mr. Rahul’s judgement of loss computa-

tion is correct? Why or why not?
(Hint: Mr. Rahul had computed the amount of loss by net-
ting off all the Cash expenses incurred during the year
against the fare money earned from cab service. He did
not consider the nature of expenses incurred and failed
to segregate between the cash expenses for business and
personal expenses.)
2. Explain some measures to be adopted for the calculation
of actual profit (or loss) earned (or suffered) by Mr. Rahul.
(Hint: After consultation with the Chartered Accoun-
tant, Mr. Rahul should analyse all the expenses incurred
during the financial year from the perspective of business

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operations. For instance, the tuition fee paid, the grocer-
ies purchased for personal use, etc.)
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 C H A
7 P T E R

PRO FORMA FOR FINANCIAL

STATEMENT MODELLING

CONTENTS

7.1 Introduction
7.2

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Meaning of Financial Statement Modelling
Self Assessment Questions
Activity
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7.3 Modelling and Projecting the Financial Statements
7.3.1 Projecting the Income Statement
7.3.2 Projecting the Balance Sheet
7.3.3 Projecting the Cash Flow Statement
7.3.4 Drafting Cash Flow Projection
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Self Assessment Questions

Activity
7.4 How Financial Models Work
7.4.1 Projecting Next Year’ s Balance Sheet and Income Statement
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Self Assessment Questions

Activity
7.5 Alternative Modelling of Fixed Assets
7.5.1 Gross Fixed Assets as a Function of Sales
7.5.2 Constant Net Fixed Assets
Self Assessment Questions
Activity
7.6 Sensitivity Analysis
Self Assessment Questions
Activity
7.7 Debt as a Plug
Self Assessment Questions
Activity
7.8 Incorporating a Target Debt/Equity Ratio into a Pro Forma
Self Assessment Questions
Activity
226 FINANCIAL MODELLING

CONTENTS

7.9 Project Finance: Debt Repayment Schedules

Self Assessment Questions
Activity
7.10 Calculating the Return on Equity
7.10.1 The ROE in Our First Full Model
Self Assessment Questions
Activity
7.11 Tax Loss Carry Forwards
Self Assessment Questions
Activity
7.12 Summary
7.13 Multiple Choice Questions
7.14 Descriptive Questions
7.15
7.16
7.17
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Higher Order Thinking Skills (HOTS) Questions
Answers and Hints
Suggested Readings & References
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 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 227

INTRODUCTORY CASELET

CASH FLOW STATEMENT

A cash flow statement is a type of financial statement that gives

total information about all of the cash inflows a business makes Case Objective
from continuing activities and outside investment sources. It also
This caselet highlights the
covers any cash outflows made within a specific time period to introduction of cash flow
cover investments and business expenses. statement.

The financial statements of a firm give investors and analysts a

picture of all the business transactions that take place, where
each transaction helps the company succeed. Because it tracks
the cash generated by the firm in three key ways—through opera-
tions, investments and financing—the cash flow statement is seen
to be the most understandable of all the financial statements. Net
cash flow is the total of these three components.

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Investors can estimate the worth of a firm’s shares or the com-
pany overall using these three separate portions of the cash flow
statement. Every business that offers and sells stock to the public
is required to submit financial statements and reports to the Secu-
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rities and Exchange Commission (SEC).

The balance sheet, income statement and cash flow statement are
the three primary financial statements. An important document
that gives interested parties’ information about all of a company’s
activities is the cash flow statement. The two subfields of account-
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ing are accrual and cash. Since accrual accounting is used by the
majority of publicly traded corporations, the cash position of the
business is not reflected in the income statement. However, the
cash flow statement is concentrated on cash accounting.
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Profitable businesses may not manage cash flow well, which is

why the cash flow statement is an essential tool for businesses,
analysts and investors. Operations, investment and financing are
the three distinct corporate activities that make up the cash flow
statement.

Consider a business that sells a product and gives its consumer

credit for the purchase. Even if it counts that transaction as
income, the corporation might not really be paid for it right away.
The corporation reports a profit on the income statement and
pays income taxes on it, but actual cash flow for the company may
be higher or lower than projected sales or revenue.

By monitoring an organisation’s cash flow, a cash flow statement

is a crucial tool for managing finances. This report is one of the
three crucial ones that determine a company’s success, together
with the income statement and the balance sheet.
228 FINANCIAL MODELLING

INTRODUCTORY CASELET

Making cash projection is often beneficial for facilitating short-

term planning. The cash flow statement lets you keep track of
incoming and departing cash by displaying the source of that
money. An organisation’s operational, investment and financial
operations all generate cash flow. The statement also provides
information on investments, business-related costs and cash with-
drawals at a certain moment in time. The knowledge you obtain
from the cash flow statement helps managers make wise decisions
for managing business operations. Businesses often strive for a
healthy cash flow because without it, they risk having to borrow
money to keep the firm afloat.

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Quick Revision

Know More
A pro forma financial statement
leverages hypothetical data or
assumptions about future values
to project performance over a
period that hasn’t yet occurred.
230 FINANCIAL MODELLING

These estimates can be helpful in directing crucial company choices,

whether you are trying to create or evaluate pro forma financial state-
ments. Pro forma financial statements are really used by business
owners, investors, creditors and other important decision makers to
assess the possible effects of business choices.

Financial statement analysis has historically been used to comprehend

a company’s performance over a specific time period. While doing so
gives information about a company’s past performance, generating
pro forma financial statements is more concerned with the future.
Because of this, these reports may be used in a variety of ways, such
as risk analysis, investment projection and demonstrating anticipated
outcomes prior to the conclusion of a reporting period.

Pro forma reports are used extensively in decision making and strate-
NOTE gic planning processes. Pro forma financial statements, for instance,
Keep in mind that the general might be produced to represent the results of three different invest-
process of creating pro forma
ment scenarios for your company. By doing this, you may compare
financial statements isn’t
significantly different from
that of creating traditional
statements. The difference
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potential outcomes side by side to decide which is best and use that
information to direct your planning process.
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lies in the assumptions and In this chapter, you will study the meaning of financial statements
adjustments made about various modelling, alternative modelling of fixed assets, sensitivity analysis,
inputs, while the format and
debt as a plug, calculating the return on equity, tax loss carry forwards,
calculations remain the same.
etc., in detail.

MEANING OF FINANCIAL STATEMENT

7.2
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MODELLING
Financial statement modelling is a process of summarising a compa-
ny’s costs and profits in a spreadsheet that can be used to estimate the
effects of a choice or event in the future. For business leaders, a finan-
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cial statement model has various applications. It is most frequently

used by financial analysts to assess and forecast potential effects of
upcoming events or management choices on a company’s stock per-
formance.

Financial statement modelling is a way to see the past and present

performance of a business and its anticipated performance in future.
These models are designed to be instruments for making decisions.
They could be used by company leaders to predict the expenses and
profitability of a proposed new project.

They are employed by financial statement analysts to explain or fore-

see the effects of various events on a company’s stock, ranging from
internal elements such as a change in strategy or business model to
external ones such as a change in economic policy or legislation. Mod-
els of financial statements are used to determine a company’s value
or to assess how well a company is performing in comparison to its
competitors. They are also employed in strategic planning to evalu-
 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 231

ate potential outcomes, determine project costs, establish budgets and

distribute resources throughout the organisation. Detailed appraisal,
sensitivity analysis and discounted cash flow analysis are a few exam-
ples of financial statement models.

SELF ASSESSMENT QUESTIONS

1. Which of the following is the practice of putting a company’s

costs and profits in a spreadsheet that can be used to estimate
the effects of a choice or event in the future?
a. Financial statement modelling
b. Sensitivity analysis
c. Discounted cash flow analysis
d. All of these

ACTIVITY

Write a short note on the uses of cash flow.

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MODELLING AND PROJECTING
7.3
FINANCIAL STATEMENTS
A financial projection displays the anticipated earnings, costs and
cash flows of a company over a given time frame. This projection may
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be provided to other parties or used internally as the foundation for a

more thorough budget. A financial forecast may be used to persuade
a bank to lend money to a company or investors to purchase stock in
the company. A financial prediction is based on a mix of past perfor-
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mance, anticipated shifts in the relevant market and other alterations

in the business’s environment, such an investment in a new product
line.

It is always recommended to project income statement line items

when creating a three-statement model. The ability to forecast the
key income statement line items should become automatic. There are
factors that will affect the future values of each individual line item.
In fact, you might even be able to easily replicate the model and only
swap out the historical numbers if the financial model you are using is
comparable to another business you need to model.

7.3.1 PROJECTING THE INCOME STATEMENT NOTE

A projected income statement is just similar to Income statement or Similar to an income statement,
the Income Statement Projection
profit and loss statement. The key distinction is that the projected
follows the following Rule:
income statement contains estimates for a future time, whereas the
income statement has actual statistics. It is among the most signifi- Net Profit = (Total Revenues –
cant financial statement. The projected income statement anticipates Total Expenses)
232 FINANCIAL MODELLING

the revenue and costs that the firm could incur in the upcoming time
frame. Depending on the needs, it might be either monthly, quarterly
or annually.

7.3.2 PROJECTING THE BALANCE SHEET

Small firms must accurately anticipate their future financial situation,

including a projection of the company’s assets, liabilities and capital,
in order to project a balance sheet. One of the most important finan-
cial statements for small business accounting is the balance sheet,
often known as the statement of financial position.

A balance sheet projection is crucial for businesses because it projects

NOTE the assets and liabilities that a company will have at a certain point
in time. Small firms can use projecting a balance sheet to determine
All in all, the process of
preparing a pro forma balance what they will probably own and owe at a future date, which can help
sheet is much the same as them prepare for upcoming purchases and other crucial business
preparing a normal balance
sheet. The same holds true for
the process of preparing income
statements and cash flow
statements.
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choices. Businesses evaluate previous financial statements to antici-
pate a balance sheet and utilise that historical information to project
future capital, assets, debt and equity. For a projected balance sheet,
the steps below should be followed:
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1. Project net working capital: Determine your company’s net
working capital first before you can anticipate a balance sheet.
The sum of your current assets and liabilities is your net working
capital. Examine your past asset and liability data to project your
future net working capital. Using financial data from the previous
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two years is a common practice. You may anticipate a reasonable

net working capital figure for your balance sheet projects based
on your company’s historical net working capital statistics and
how they’ve evolved over time.
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2. Project fixed assets: Projecting your fixed assets is the next

stage in a balance sheet projection. Your company’s fixed assets
are long-term physical assets that are relatively easy to estimate.
To anticipate your future fixed assets with accuracy, you must
take depreciation into account. The calculation to project your
future fixed assets is as follows:
Projected Fixed Assets = Fixed Assets Last Year + Capital
Expenditures – Depreciation
3. Estimate financial debt: The next step is to project your debt,
which is a simple procedure. Use this method to project the
financial debts of your company:
Projected Financial Debt = Financial Debt Beginning of Year +
Change in Financial Debt
4. Project equity position: Your predicted equity position follows
on your balance sheet prediction. When estimating equity, you
are predicting both retained earnings and the money you have
 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 233

invested in the company. Using the following formula, you may

predict the equity of your company:
Projected Equity = Equity Last Year + Net Income – Dividends
+ Change in Equity
5. Project cash position: Projecting your cash situation is the last
stage in predicting the balance sheet. You may estimate this
using your cash flow statement. The formula for predicting cash
position is as follows:
Projected Cash Position = Last Year’s Cash Position + Change
in Cash

7.3.3 PROJECTING THE CASH FLOW STATEMENT

Once you have determined your volume-based sales predictions,

translate your sales volumes into income to get your cash flow projec-

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tions. Accounts receivable are displayed in the example below based
on cash sales with 30-, 60- and 90-day receivables. You can project
your monthly cash flow needs by subtracting outflows from all cash
inflows. It becomes a crucial choice whether or not to continue with
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your business if you find yourself in a bad situation unless you can Know More
make reasonable modifications to either your inflows or outflows A projected cash flow statement
through the extension of accounts payable or authorised operating is described as a listing of all
lines of credit. These solutions should only be taken into account if expected cash inflows and
outflows for the coming year.
there will be extra money in the coming months to pay off operating
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loans and/or accounts payable.

The cash flow project, which includes the quantity and timing of antic-
ipated cash inflows and outflows, might be more crucial for a new
company than the prediction of the income statement. Typically, lev-
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els of earnings, especially during a business’s early years, will not be

enough to cover operational cash requirements. Furthermore, on a
short-term basis, cash inflows and outflows are not equal. These cir-
cumstances will be indicated by cash flow predictions, and if neces-
sary, the aforementioned cash flow management methods may need
to be put into practice.

The cash flow statement will demonstrate your peak working capital
needs and emphasise the need for and timing of additional financing
given a level of predicted sales, related costs and capital expenditure
plans over a certain time. You must decide how to receive, under what
conditions and how to repay this additional funding.

7.3.4 DRAFTING CASH FLOW PROJECTION

You may start creating your cash flow prediction after you have these
reasonable hypotheses at your disposal. At the beginning, add 12 col-
` ` ` `

` ` ` `
 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 235

August September October November

(`) (`) (`) (`)

Loans from the 36,000 40,000 30,000 32,000

bank - Revolving
line

Other 6,000 N/A 10,000 N/A

Total sources of 1,98,000 1,86,000 201,600 1,95,600

cash, beginning

Uses of cash
August September October November
(`) (`) (`) (`)

Payroll, including payroll 40,000 44,000 40,000 40,000

taxes

Accounts payable - vendors 36,000 30,000

S34,000 36,000
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Other overhead, including 32,000 32,000 32,000 32,000
rent

Owners compensation 32,000 32,000 32,000 32,000

Line of credit payments 30,000 30,000 46,000 30,000

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Long-term principal pay- 6,000 6,000 6,000 6,000

ments

Purchases of fixed assets 5,000 N/A N/A 20,000

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Estimated income tax, cur- N/A N/A N/A 20,000

rent year

Other 10,000 10,000 10,000 10,000

Total uses of cash 1,96,000 1,84,000 200,000 2,26,000

Excess (deficit) of cash 2,000 1,600 1,600 (42,400)

The company is projecting negative cash in November. What can you

do today to prevent the negative cash flow?

Key assumptions:
1. 75% of sales will be collected the month after the sale.
2. 25% of sales will be collected the 2nd month after the sale.
3. Payables are due in 25 days.
4. 60% of eligible receivables can be used for the revolving line of
credit.
236 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

2. Which of the following displays the anticipated earnings, costs

and cash flows of a company over a given time frame?
a. Financial statement
b. Financial analysis
c. Financial projection
d. None of these
3. Which of the following is just similar to Income Statement or
Profit and Loss Statement?
a. Projected income statement
b. Projected balance sheet
c. Both a and b

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d. None of these
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ACTIVITY

Find some examples of the financial statements.

7.4 HOW FINANCIAL MODELS WORK

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The majority of the most significant financial statement variables are

NOTE believed to be functions of the firm’s sales level in almost all finan-
cial statement models, which are known as sales driven. For instance,
Financial model is a
receivables are frequently calculated as a proportion of the compa-
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representation in numbers of
a company’s operations in the ny’s sales. An example that is a little more difficult would assume that
past, present and the forecasted the amount of sales is a step function of the fixed assets (or any other
future. account):

 a if sales < A

Fixed assets =  b if A ≤ sales < B
etc.


To build a financial planning model, we must make a distinction

between financial statement items that involve policy decisions and
those that are functional linkages of sales and sometimes of other
financial statement items. The asset side of the balance sheet is typ-
ically thought to be solely dependent on functional relationships.
Alternately, the ratio of long-term debt to equity may be seen as a pol-
icy decision, allowing the current liabilities to just consist of functional
links.
 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 237

Here is a straightforward illustration. We want to project the financial

statements for a company whose most recent income statement and
balance sheet are shown in Figure 7.1:

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Figure 7.1: Financial Statement Analysis

Sales are currently at a 1,000 level (year 0). The company predicts the
following financial statement relationships as well as a 10% annual
growth in revenues:

Current assets Assumed to be 15% of end-of-year sales

Current liabilities Assumed to be 8% of end-of-year sales
Net fixed assets 77% of end-of-year sales
Depreciation 10% of the average value of assets on the books
during the year
Fixed assets at cost Sum of net fixed assets plus accumulated depre-
ciation
238 FINANCIAL MODELLING

Debt The firm neither repays any existing debt nor

borrows any more money over the 5-year hori-
zon of the pro forma
Cash and marketable This is the balance sheet plug. Average balances
securities of cash and marketable securities are assumed
to earn 8% interest

A pro forma model’s plug will often be one of three financial balance
sheet items:
(i) Cash and marketable securities
(ii) Debt
(iii) Stock

Take a look at our initial pro forma model’s balance sheet as an illus-
tration.

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Assets
Cash and marketable securities
Liabilities and Equity
Current liabilities
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Current assets Debt
Fixed assets Equity
Fixed assets at cost Stock (net funds directly provided by
shareholders)
– Accumulated depreciation
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Net fixed assets Accumulated retained earnings (profits

not paid out)
Total assets Total liabilities and equity
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Cash and marketable securities are assumed to be the plug in the cur-
rent case. This presumption might signify two things:
1. Formally, cash and marketable securities are defined as total
liabilities and equity minus current assets minus net fixed assets.
Cash and marketable securities = Total liabilities and equity –
Current assets – Net fixed assets
By using this definition, assets and liabilities will always be
equal.
2. In addition to identifying the plug as cash and marketable
securities, we are also revealing how the company funds itself.
For instance, in the model below, the company does not sell any
more shares, refinance any of its current debt, or issue any new
debt. According to this definition, the firm’s cash and marketable
securities account will serve as the source of all extra funding (if
necessary), as well as any more cash that the company may have.
 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 239

7.4.1 PROJECTING NEXT YEAR’ S BALANCE SHEET AND

INCOME STATEMENT

Above we have given the financial statement for year 0. We now proj-
ect the financial statement for year 1 as shown in Figure 7.2:

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Figure 7.2: Setting up the Financial Statement Model

Most of the formulae are clear. It is crucial to note the dollar signs,
which say that the cell references to the model parameters shouldn’t
change when the formulae are duplicated. When you project years
two and beyond, the model won’t copy accurately if you don’t include
them.

SELF ASSESSMENT QUESTIONS

4. The majority of the most significant financial statement

variables are believed to be functions of the firm’s sales level
in almost all financial statement models, which are known as
a. Sales driven b. Cost of goods sold
c. Profit before tax d. All of these
240 FINANCIAL MODELLING

ACTIVITY

Discuss some items of the financial statements.

ALTERNATIVE MODELLING OF FIXED

7.5
ASSETS
The models in this chapter are predicated on the notion that Net Fixed
Assets (NFA) are determined by sales. In essence, this means that we
assume that the fixed assets’ depreciation has actual economic rele-
vance and that their after-depreciation value accurately reflects their
capacity for productivity. This seems to us to be a reasonable assump-
tion at the abstract level of the pro forma models in this chapter.

Know More
Fixed assets are long-term
physical assets used in a
business, such as land,
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However, the financial modeler may wish to take into account two dis-
tinct models. The first of them is based on the notion that depreciation
has no economic significance. In this instance, sales determine the
gross fixed assets. The second alternative model makes the assump-
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buildings, equipment and
tion that, if properly maintained, the current fixed asset base can
patents. They are often referred
to as property, plant and support sustainable levels of future sales. The pro forma architecture
equipment (PP&E). already established may readily support both alternative models, as
shown below with examples.
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7.5.1 GROSS FIXED ASSETS AS A FUNCTION OF SALES

Assume that depreciation has no economic significance and that the

fixed assets at cost represent the assets’ potential for future produc-
tivity. This just necessitates a little modification to the prior model as
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shown in Figure 7.3:

Figure 7.3: Fixed Assets at Cost as a Function of Sales

 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 241

7.5.2 CONSTANT NET FIXED ASSETS

In some circumstances, it may be safe to presume that, with good

maintenance, the present fixed assets can support sustainable levels
of future sales.

For instance, if depreciation is thought of as the economic representa-

tion of the upkeep and asset replacement necessary to serve the cur-
rent customer base, then the net fixed assets of a supermarket would
remain constant over time. In a number of Harvard instances, this
assumption has been made.

This variation in our basic model is easily made, as shown below in

Figure 7.4:

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Figure 7.4: Constant Net Fixed Assets

This model implies that depreciation equals capital expenditure. This

can be seen in the free cash flows in Figure 7.5:

Figure 7.5: Free Cash Flow Calculation

242 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

5. Which of the following can support sustainable levels of future

sales?
a. Present fixed assets
b. Present current assets
c. Past fixed assets
d. Past current assets

ACTIVITY

Find out the calculation of modelling of fixed assets.

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7.6 SENSITIVITY ANALYSIS
Sensitivity analysis is a method used in financial modelling to examine
how various independent variable values impact a certain dependent
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variable in a given set of circumstances. Numerous academic fields,
including biology, geography, economics and engineering, frequently
use sensitivity analysis.

As in any Excel model, we can perform extensive sensitivity analysis

NOTE on our valuation.
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Sensitivity Analysis (SA) is a

method that measures how the Another option is to compute the impact of both long-term FCF growth
impact of uncertainties of one
and WACC on stock valuation. But you have to be careful here:
or more input variables can lead
to uncertainties on the output
FCF5 × (1 + long − term FCF growth )
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variables. Terminal Value =

WACC − long − term FCF growth

SELF ASSESSMENT QUESTIONS

6. As in any Excel model, we can perform which of the following

on our valuation.
a. Debt as a plug
b. Extensive Sensitivity analysis
c. Both a. and b.
d. None of these

ACTIVITY

Discuss some advantages of sensitivity analysis.

 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 245

SELF ASSESSMENT QUESTIONS

7. Which of the following was a constant and the plugs were

cash, and marketable securities?
a. Equity
b. Warrants
c. Debt
d. All of these

ACTIVITY

Write a note on the uses of debt for a firm.

INCORPORATING A TARGET DEBT/

7.8
EQUITY RATIO INTO A PRO FORMA

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We could also wish to modify our model in relation to the plug. Assume
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the company has a goal debt to equity ratio: It expects the debt/equity
ratio on the balance sheet to match a certain ratio in each of years 1
through 5 of the contract. The illustration of this scenario is shown in
Figure 7.8:
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Figure 7.8: Target Debt Equity Ratio

 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 247

will go into a cash and marketable securities account) as shown in

Figure 7.9:

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Figure 7.9: Project Finance

The model may take into consideration the terms of debt repayment
by simply reporting the debt balances at the end of each year. The
business is anticipated not to issue any further stock as a result of the
financing restrictions, therefore the model’s plug cannot be on the lia-
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bilities side of the balance sheet. The plug in our model is the account
for cash and marketable securities.

Another common assumption made regarding fixed assets is included

in the model, which is that the net fixed assets would remain the same
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over the duration of the project.

In essence, this implies that the fixed assets’ capital upkeep is appro-
priately reflected in the depreciation. Rows 29 through 31 above
demonstrate this by showing how the fixed assets at cost expand yearly
due to the rise in asset depreciation. Additionally, it implies that there
would be no net cash flow from depreciation as shown in Figure 7.10:

Figure 7.10: Free Cash Flow Calculation

In this example, the company has no trouble repaying the principal on

its loan. As credit analysts, we could be curious to see how the values
248 FINANCIAL MODELLING

of the different parameters impact the firm’s capacity to make its pay-
ments. The COGS/sales ratio has been raised in the case below. The
company can no longer make its debt repayments in years 1-3 with the
revised parameter values. The pro forma demonstrates this fact: The
negative cash and marketable security balances in years 1-4 show that
the company had to borrow money in order to repay the loan’s princi-
ple as shown in Figure 7.11:

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Figure 7.11: Project Finance (With These Parameters

the Project cannot Pay off its Debt)
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SELF ASSESSMENT QUESTIONS

9. A typical instance of so-called ____________ involves a

company borrowing money to fund a project.
a. Forecast statement b. Capital structure
c. Project financing d. Return on equity

ACTIVITY

Discuss the importance of debt repayment schedules.

7.10 CALCULATING THE RETURN ON EQUITY

The pro forma models presented in this chapter can be used to calcu-
late the expected return on equity. Look at the prior illustration: The
project’s equity owners must pay 1,100 in year 0. They get no compen-
 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 249

sation in years 1-4, but in year 5 they become the company’s owners.
Assume that the assets’ book value correctly matches their market
value. Then at the end of year 5 the equity in the business is worth
stock + cumulative retained earnings = 2,255. As shown below in
Figure 7.12 and 7.13 the Return on Equity (ROE) is determined:

Know More
Return on equity (ROE) is
the measure of a company’s
net income divided by its
shareholders’ equity. ROE is
Figure 7.12 Calculating the Return on Equity by using Excel function a gauge of a corporation’s
profitability and how efficiently it
generates those profits.

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Figure 7.13 Calculating the Return on Equity (ROE)

Take note of the fact that this equity returns rises as equity investment
falls in Figure 7.14 and 7.15. If the business first loans 1,500 and the
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equity owners put in 600, for example:
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Figure 7.14 Calculating the Return on Equity by using Excel function

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Figure 7.15: Calculating the Return on Equity (ROE)

The accompanying data table and graph demonstrate that the equity
return increases with decreasing initial equity investment as shown
in Figure 7.16:

Figure 7.16: Accompanying Data Table and Graph

250 FINANCIAL MODELLING

7.10.1 THE ROE IN OUR FIRST FULL MODEL

If we use the mid-year discounting method described in section 5.5 to

value the company as shown in Figure 7.17 and 7.18, we may calculate
the ROE of an investor who purchases the company at date 0 at its
imputed equity valuation, receives 5 years of dividends, and then sells
it at the imputed terminal value of the equity:

Figure 7.17: Computing the ROE by using Excel function

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Figure 7.18: Computing the ROE in the First Financial Model

S
 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 255

5. Which of the following includes the quantity and timing of

anticipated cash inflows and outflows, might be more crucial for
a new company than the prediction of the income statement?
a. Income statement project
b. Retained earnings statement
c. Balance sheet project
d. Cash flow project
6. A pro forma model’s plug will often be one of three financial
balance sheet items and the other two are
a. Cash and marketable securities
b. Debt
c. Stock
d. All of these

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7. Which of the following terms are included in the calculation of
net profit?
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a. Revenues b. Expenses
c. Taxes d. All of these
8. Which of the following terms are included in the calculation of
projected fixed assets?
a. Fixed assets last year b. Capital expenditure
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c. Current assets d. Both a. and b.

7.14 DESCRIPTIVE QUESTIONS

?
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1. What do you mean by pro forma financial statement?

2. Discuss the meaning of financial statements modelling.
3. Describe the modelling and projecting the financial statements.
4. Define the projection of the balance sheet.

HIGHER ORDER THINKING SKILLS

7.15
(HOTS) QUESTIONS
1. Before preparing or deciding on transaction-related events such
as mergers, acquisitions or hypothetical scenarios, corporations
produce statements based on a number of assumptions and
forecasts known as pro forma financial statements. Which of the
following are the Uses of Pro Forma Financial Statements?
a. Projections b. Funding
c. Risk assessment d. All of these
256 FINANCIAL MODELLING

2. Statements of financial position, statement of operations,

statement of cash flows, and others are among the several
financial statements that a firm generates. In addition to this,
management of the firm may want to handle specific occurrences
for which projections of the financial statements or alternative
assumptions of some items are required. Which of the following
is not an advantage of pro forma financial statements?
a. Helpful in creating risk models, M&A models and budgets.
b. Used to monitor potential business development and make
important decisions.
c. Because of models based on statistics, there is no explicit ref-
erence of qualitative factors.
d. Provide various viewpoints from the participating teams and
reveal the state of the firm.

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7.16 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

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Topic Q. No. Answer
Meaning of Financial State- 1. a. Financial statement mod-
ments Modelling elling
Modelling and Projecting the 2. c. Financial projection
Financial Statements
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3. a. Projected income state-

ment
How Financial Models Work: 4. a. Sales driven
Theory and an Initial Example
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Alternative Modelling of Fixed 5. a. Present fixed assets

Assets
Sensitivity Analysis 6. b. Extensive Sensitivity
Analysis
Debt as a Plug 7. c. Debt
Incorporating a Target Debt/ 8. c. Debt to equity ratio
Equity Ratio into a Pro Forma
Project Finance: Debt Repay- 9. c. Project financing
ment Schedules
Calculating the Return on 10. a. Return on equity
Equity
Tax Loss Carry Forwards 11. d. Accumulated losses

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. b. Competitors
 PRO FORMA FOR FINANCIAL STATEMENT MODELLING 257

Q. No. Answer
2. d. Projected balance sheet
3. b. Project net working capital
4. c. Project cash position
5. d. Cash flow project
6. d. All of these
7. d. All of these
8. d. Both a. and b.

HINTS FOR DESCRIPTIVE QUESTIONS

1. A pro forma financial statement projects performance over
a future period using fictitious data or assumptions about
probable values. Pro forma financial statements are defined
as “financial statements predicted for future periods” in the
Financial Accounting online course. They may also be known

Introduction
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as financial projections or financial projects. Refer to Section 7.1

2. Financial statement modelling is the practice of putting a

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company’s costs and profits in a spreadsheet that can be used to
estimate the effects of a choice or event in the future. For business
leaders, a financial statement model has various applications.
It is most frequently used by financial analysts to assess and
forecast potential effects of upcoming events or management
choices on a company’s stock performance. Financial statement
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modelling is a way to see how a business has operated in the

past, present and anticipated future. These models are designed
to be instruments for making decisions. They could be used by
company leaders to predict the expenses and profitability of a
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proposed new project. Refer to Section 7.2 Meaning of Financial

Statements Modelling
3. A financial projection displays the anticipated earnings, costs
and cash flows of a company over a given time frame. This
projection may be provided to other parties or used internally
as the foundation for a more thorough budget. In the second
scenario, a financial forecast may be used to persuade a bank
to lend money to a company or investors to purchase stock in
the company. A financial prediction is based on a mix of past
performance, anticipated shifts in the relevant market, and other
alterations in the business’s environment such an investment in a
new product line. Refer to Section 7.3 Modelling and Projecting
the Financial Statements
4. A balance sheet projection is crucial for businesses because it
projects the assets and liabilities that a company will have at a
certain point in time. Small firms can use projecting a balance
sheet to determine what they will probably own and owe at
 C H A
8 P T E R

PORTFOLIO MANAGEMENT

CONTENTS

8.1 Introduction
8.2

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Turning Your Goals into a Strategy
Self Assessment Questions
Activity
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8.3 Risk-reward Ratio
Self Assessment Questions
Activity
8.4 Investment Risk Pyramid
Self Assessment Questions
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Activity
8.5 Portfolio Strategies
Self Assessment Questions
Activity
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8.6 Building an Investment Portfolio

Self Assessment Questions
Activity
8.7 Risk Reduction in the Stock Portion of a Portfolio
Self Assessment Questions
Activity
8.8 Value Investing
Self Assessment Questions
Activity
8.9 Growth Investing
Self Assessment Questions
Activity
8.10 Summary
8.11 Multiple Choice Questions
8.12 Descriptive Questions
260 FINANCIAL MODELLING

CONTENTS

8.13 Higher Order Thinking Skills (HOTS) Questions

8.14 Answers and Hints
8.15 Suggested Readings & References

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 Case Objective
This caselet highlights the
portfolio solution for a digital
transformation of an asset
management firm.
 Quick Revision

financial statements predicted for future periods

NOTE
Portfolio management involves
building and overseeing a
selection of investments that
will meet the long-term financial
goals and risk tolerance of an
investor.
 Know More
Active portfolio management
requires strategically buying and
selling stocks and other assets
in an effort to beat the broader
market.
 PORTFOLIO MANAGEMENT 265

pany stocks’ short-term performance can and frequently do experi-

ence dramatic fluctuations.

SPECIFICATION OF INVESTMENT OBJECTIVES

Investment objectives are typically articulated in terms of income,

growth and stability. Investment objectives may be described more
clearly in terms of return and risk since income and growth are two
ways that return is created, while stability denotes risk minimisation.

CONSTRAINTS

The risk-reward principle, which argues that the potential return on

an investment depends on the level of risk, may be known to you. NOTE
However, a lot of investors do not know how to figure out how much Passive portfolio management
risk each of their unique portfolios should take. The broad framework seeks to match the returns of the
market by mimicking the makeup
presented in this lesson may be used by any investor to evaluate their of a particular index or indexes.

S
degree of risk and how that level relates to various assets.

SELF ASSESSMENT QUESTIONS

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1. Which of the following suggests an intentional attempt to
attain stated aims?
a. Strategy
b. Goals
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c. Planning
d. Organising
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ACTIVITY

Write a short note on the advantages of portfolio management.

8.3 RISK-REWARD RATIO

The risk/reward ratio shows how much an investor may get from an
investment for every dollar they risk. The predicted rewards of an
investment and the level of risk required to attain those returns are
often compared using risk/reward ratios. Think about the following
instances: A 1:7 risk-reward ratio on investment indicates that the
investor is ready to take on 1 risk in exchange for the chance of receiv-
ing 7. In contrast, a risk/reward ratio of 1:3 indicates that an investor
should anticipate investing 1 with the possibility of getting 3 back.

The ratio is derived by dividing the amount a trader stands to lose if

the price of an asset moves in an unanticipated direction (the risk) by
the amount of profit the trader anticipates to have gained when the
266 FINANCIAL MODELLING

position is closed. Traders frequently use this method to decide which

trades to place (the reward).

A considerable level of danger comes with investing money in the mar-

kets, hence if you are going to accept that risk, you should be paid. It
might not be worth the risk if someone you only loosely trust requests
for a `50 loan and promises to reimburse you `60 in two weeks, but
what if they promised to pay you `100? It could be alluring to take the
chance of losing 50 for the potential gain of 100.

NOTE That is a 2:1 risk/reward ratio, which attracts the attention of many
expert investors since it allows investors to double their money. The
Risk/Reward is a general
concept underlying anything by ratio would change to 3:1 if the offer had been for 150.
which a return can be expected.
Anytime you invest money Let us now examine this in the context of the stock market. Let us say
into something there is a risk, you completed your homework and discovered an interesting stock.
whether large or small, that you You note that the price of XYZ stock has dropped from a recent high
might not get your money back. of `29 to `25.
In turn, you expect a return,
which compensates you for
bearing this risk. S
You think that if you buy now, XYZ will increase to `29 in the not-too-
distant future and you may profit. You decide to purchase 20 shares
of this investment with your `500 available. Despite your thorough
IM
investigation, do you know your risk-to-benefit ratio? If an average
individual investor, then you most likely do not.

Example 1: Assume you are paying `700 for 100 shares of a corpora-
tion. You decide to book gains at `720 and set your stop-loss at `690. In
other words, you may lose `10 on each share, but you could also make
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`20.

Solution:

Formula of calculating risk-reward ratio is:

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Risk-reward ratio

= (Entry Price – Stop Loss Price) / (Target Price – Entry Price)

= (700 – 690) / (720 – 700)

= 10 / 20

=1/2

Thus, the risk-reward ratio in this trade is 1:2.

SHARPE RATIO

The Sharpe ratio evaluates the relationship between an investment’s

return and risk. The idea that excess returns over time may indicate
more volatility and risk rather than investment expertise is expressed
mathematically in this way.
 PORTFOLIO MANAGEMENT 267

As a result of his work on the capital asset pricing model (CAPM),

economist William F. Sharpe introduced the Sharpe ratio in 1966
under the name reward-to-variability ratio. For his work on CAPM,
Sharpe received the economics Nobel Prize in 1990.

The numerator of the Sharpe ratio is the difference over time between
actual or predicted returns and a benchmark, such as the performance
of a certain investment category or the risk-free rate of return. The
standard deviation of returns over the same time period, which is a
gauge of volatility and risk, serves as the denominator.

The portfolio risk premium divided by the portfolio risk is known as

the Sharpe Ratio.

Return on the portfolio – Return on the risk-free rate

Sharpe ratio =
Standard deviation of the portfolio

=
R p − Rf
σp
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The slope of the capital allocation line is known as the Sharpe ratio, or
reward-to-variability ratio (CAL). The better the asset, the larger the
slope (higher number).

It should be noted that the measure’s restriction is that the risk being
employed is the portfolio’s overall risk, not its systematic risk. The
portfolio with the greatest performance has the highest Sharpe ratio;
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however this statistic is meaningless on its own. The Sharpe ratio for
each portfolio must be calculated in order to rank them.

When the numerators are negative, another restriction comes into

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play. This will lead to inaccurate rankings since the Sharpe ratio will
be less negative for a riskier portfolio.

Example 2: The stock of ABC Corp Plc is the investment which is

the aim. Over the last five years, the stock has generated an average
annual return of 15%. The UK Treasury Bill, which offers an interest
rate of 0.4%, is the risk-free investment. The volatility (standard devi-
ation) of ABC Plc is estimated to be 20%. Calculate the Sharpe ratio.

Solution:

Sharpe Ratio

= (Return of Portfolio – Risk-Free Rate) / Standard Deviation of the

Portfolio’s Excess Return

= (15% – 0.4%) / 20%

= 0.73
268 FINANCIAL MODELLING

TREYNOR RATIO

The reward-to-volatility ratio, also known as the Treynor ratio, is a

performance indicator for calculating how much extra return a port-
folio created for each unit of risk it assumed.

In this context, an excess return is a return that was obtained beyond

the return that would have been possible from a risk-free investment.
Treasury bills are often employed to represent the risk-free return in
the Treynor ratio, despite the fact that there is no real risk-free invest-
ment.

Systematic risk as determined by a portfolio’s beta is referred to as risk

in the Treynor ratio. The sensitivity of a portfolio’s return to changes
in the return of the whole market is measured by beta.

The Treynor ratio is a development of the Sharpe ratio that employs

beta or systematic risk as the denominator rather than total risk. This

S
is thus more appropriate for those with varied portfolios.

Treynor ratio =
Re turn on the portfolio – Risk-free rate
Beta of the portfolio
=
R p − Rf
Bp
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The Treynor ratio, like the Sharpe ratio, needs positive numerators
to provide meaningful comparison findings, thus it is ineffective for
assets with negative beta. Additionally, although both the Sharpe and
Treynor ratios may rank portfolios, they do not reveal whether or
M

not the portfolios are superior to the market portfolio or how much a
higher ratio portfolio is preferable to a lower ratio portfolio.

Example 3: Calculate the Treynor ratio. Take a look at the table below,
which includes three assets, their beta levels, and their % returns:
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Investment Beta Value Percentage of Return

Investment A 1.00 10%
Investment B 0.9 12%
Investment C 2.5 22%
Solution:
Investment A:
Treynor ratio for investment A
= (Portfolio Return – Risk-Free Rate) / Portfolio Beta
= (10% – 1%) / 1.0 = 9% or 0.090
Investment B:
Treynor ratio for investment B
= (Portfolio Return – Risk-Free Rate) / Portfolio Beta
= (12% – 1%) / 0.9 = 12.2% or 0.122
 PORTFOLIO MANAGEMENT 269

Investment C:

Treynor ratio for investment C

= (Portfolio Return – Risk-Free Rate) / Portfolio Beta

= (22% – 1%) / 2.5 = 8.4% or 0.084

From the calculated Treynor ratio numbers, it can be seen that Invest-
ment B has the greatest Treynor ratio, making it the investment with
the lowest beta value. As a result, Investment A’s Treynor ratio is
0.090, Investment B’s is 0.122 and Investment C’s is 0.084. Therefore,
of the three investments examined, Investment B is regarded to have
had the greatest result in this scenario. Similar to that, Investment C
performs the worst out of the three investments, while Investment A
comes in second.

JENSEN’S ALPHA

S
The Jensen’s measure, also known as Jensen’s alpha, is a risk-adjusted
performance metric that measures whether the average return on an
investment or portfolio is higher or lower than the return forecasted
IM
by the capital asset pricing model (CAPM), given the portfolio’s beta
and the market’s overall return. This statistic is also often known by
the name alpha.

Investors who want to appropriately assess the performance of an

investment manager must consider both the portfolio’s risk and total
M

return in order to determine if the investment’s return outweighs

its associated risk. If two mutual funds, for instance, both had a 12%
return, a sane investor would choose the less hazardous one. One
method to assess if a portfolio is producing the right return for its
N

degree of risk is to use Jensen’s measure.

A portfolio is making excess returns if the value is positive. In other

words, a positive result for Jensen’s alpha indicates that a fund man-
ager outperformed the market via stock selection.

The foundation of Jensen’s Alpha is systematic risk. To calculate a

measure of this systematic risk in a similar way to the CAPM, the daily
returns of the portfolio are regressed against the daily returns of the
market. A measurement of performance in relation to the market is
the discrepancy between the portfolio’s actual return and the pre-
dicted or modelled risk-adjusted return.

αP = Rp – (Rf + βp (Rm – Rf))

A positive number for αp means the portfolio has outperformed the

market, whilst a negative value means the opposite. With the Alpha
serving as a representation of the highest price an investor should pay
for the active management of a portfolio, the values of Alpha may also
be used to rank portfolios or the managers of such portfolios.
270 FINANCIAL MODELLING

Example 4: The company has beginning portfolio value of `1 Million,

ending portfolio value of `1.2 Million, portfolio beta of 1.2, risk-free
rate of 2% and expected market return of 10%. Calculate the Jensen’s
alpha ratio.

Solution:
Jensen’s alpha

= Portfolio return – [Risk Free Rate + Portfolio Beta × (Market Return

– Risk Free Rate)]

= 20% – [2% + 1.2 × (10% – 2%)]

= 20% – [2% + 9.6%]

= 20% – 11.6%

= 8.4%

Working Note:
S
Portfolio Return
IM
= (Ending Portfolio Value / Beginning Portfolio Value) – 1

= (`1.2 Million / `1 Million) – 1

= 0.20 or 20%
M

SELF ASSESSMENT QUESTIONS

2. Which of the following ratios shows how much an investor

may get from an investment for every dollar they risk?
a. Net Profit Ratio
N

b. Gross Profit Ratio

c. Risk-Reward Ratio
d. All of these

ACTIVITY

Find the calculations of the Risk-reward Ratio.

8.4 INVESTMENT RISK PYRAMID

An investing risk pyramid does not advise you to purchase any spe-
cific stocks or bonds. It serves as a tool for asset allocation. Asset allo-
cation refers to selecting how much of your overall assets should be
invested in lower-risk, secure securities, how much should be invested
in growth opportunities that include some risk and how much you
may invest in high-risk projects.
 PORTFOLIO MANAGEMENT 271

The pyramid of risk pyramid sometimes referred to as an investment

pyramid, is simply a method that investors employ to build an invest-
ment portfolio. It enables users to choose investments for their portfo-
lio based on the degree of risk associated with certain assets.

The portfolio strategy is pictured as a pyramid with a broad base,

narrowing as it rises and finally ending in a pointed summit. Inves-
tors have properly termed the approach “the risk pyramid” since it is
depicted in the shape of a pyramid and because it deals with the risk
levels of various investment assets.

Having trouble visualising? The risk pyramid is illustrated in

Figure 8.1:

High-risk investments:
Commodities, futures and options,
cryptocurrencies, penny stocks and TOP
precious metals and gems

Medium-risk investments:
Income stocks, growth stocks, real estate,
mutual funds and index funds
MIDDLE

S RISK
IM
Low-risk investments:
Money market instruments, Treasury
bills, government bonds, cash and cash BASE
equivalents and Certificates of Deposit

Figure 8.1: The Risk Pyramid

M

The risk pyramid contains three distinct layers, the base, the centre
and the summit, as seen in the above diagram. The relative danger
levels of the various stages of the pyramid are even colour-coded in
this illustration. Let us examine the pyramid’s three components in
more detail, beginning with the base.
N

1. THE BASE

The lowest-risk investment possibilities are represented by the base of

the risk pyramid, which serves as its base. The following are examples Know More
of money market instruments: cash and cash equivalents, Treasury It’s no secret that throughout
history common stock has
bills, government securities, certificates of deposits, bonds and other outperformed most financial
financial products. instruments. If an investor plans
to have an investment for a
The likelihood of default risk or any other risk for that matter, affect- long period of time, his or her
ing these assets is extremely minimal. These investment alternatives portfolio should be comprised
are therefore regarded as the safest of the bunch. However, because mostly of stocks. Investors who
don’t have this kind of time
there is no risk involved, these investments typically have poor rates
should diversify their portfolios
of return as well. by including investments other
than stocks.
The method simply recommends that a sizable portion of your portfo-
lio be made up of these low-risk investment alternatives because the
pyramid’s base is the biggest.
272 FINANCIAL MODELLING

2. THE MIDDLE

Moderately risky investment alternatives are represented in the cen-

tre of the risk pyramid. The assets that make up the centre of the risk
pyramid are nevertheless seen as being pretty safe, while not being as
secure as the investments at the pyramid’s base. Investments includ-
ing real estate, index funds, growth firms and dividend shares, among
others, frequently make up the middle tier of the pyramid. This cat-
egory of investment opportunities often provides steady returns and
strong long-term capital growth. The method essentially supports a
reasonable degree of portfolio allocation for these assets because this
tier of the pyramid is less than the base but greater than the summit.

3. THE TOP

Finally, we have the pyramid’s summit. The riskiest investing alter-

Know More natives are represented in this section. Among other asset types, it
The underlying principle of asset
allocation is that the older a
person gets, the less risk he or
she should take on. After you
S
covers futures, options, commodities and penny stocks.

The ability to deliver extraordinarily large profits is one of these asset

types’ major attributes. However, the significant risk is offset by the
IM
retire, you may have to depend profit. The likelihood of an investor losing a significant portion of their
on your savings as your only
investment capital is substantial when using these sorts of products.
source of income. It follows
that you should invest more
conservatively because asset
The top rung of the risk pyramid is the lowest of the three particularly
preservation is crucial at this for this reason. The approach fundamentally supports allocating the
time in life. smallest percentage of the portfolio to various investment products.
M

Additionally, it indicates that you should only invest money that you
deem disposable or money that you are prepared to lose.

SELF ASSESSMENT QUESTIONS

N

3. Which of the following does not advise you to purchase any

specific stocks or bonds?
a. Portfolio strategy
b. Building an investment portfolio
c. Value investing
d. Investing risk pyramid
4. The lowest-risk investment possibilities are represented by the
base of the risk pyramid, which serves as its base. Which of the
following options is correct regarding the above statement?
a. Middle
b. Top
c. Base
d. None of these
 PORTFOLIO MANAGEMENT 273

ACTIVITY

Identify and categorise (10/100) stocks/assets as per the investment

risk pyramid.

8.5 PORTFOLIO STRATEGIES

One rule governs investing for Warren Buffett, probably the best stock
picker in the world: Never lose money.

This does not imply that you should dump your investments as soon
as they begin to decline. However, you should continue to pay close
attention to their whereabouts and the losses you are prepared to
accept. Even while you want your investments to bear fruit and grow,
long-term investing success depends on capital preservation. When
investing in the markets, it is hard to eliminate risk, but these six mea-
sures may help safeguard your account.

1. DIVERSIFICATION
S
IM
Diversification is one of the tenets of Modern Portfolio Theory (MPT).
MPT adherents think that in a bear market, a diversified portfolio will Know More
perform better than a concentrated one. By holding a sizable number Active Portfolio Strategies - If
you are an investor with a view
of assets in more than one asset class, investors build deeper and more to beating any benchmarks
extensively diversified portfolios, lowering unsystematic risk. This is of returns, you will think of
the risk involved in investing in a certain business. Some financial an active strategy. A range of
M

gurus claim that stock portfolios with 12, 18 or even 30 stocks may assumptions and forecasts are
completely remove unsystematic risk. used to find out what securities
are reliable purchases. Thus,
investors are active, making
2. NON-CORRELATING ASSETS frequent trades moving wealth
consistently for long- term gains.
N

Systematic risk, or the risk connected with investing in the markets If you don’t mind risks, this is a
generally, is the reverse of unsystematic risk. Regrettably, the sys- good strategy.
temic risk exists constantly. There is a solution to lessen it, however,
diversify your portfolio’s holdings among non-correlating asset types
including bonds, commodities, currencies and real estate. 3 Non-cor-
relating assets respond to market fluctuations differently than equities
do; often, they move in the other direction. Another asset rises as one
falls. They thereby reduce the total value of your portfolio’s volatility.

In the end, using non-correlating assets reduces performance highs

and lows, resulting in more even returns. That is, at least, the theory.

3. PUT OPTIONS

The S&P 500 fell 24 times out of 84 years, or more than 25% of the
time, between 1926 and 2009. Investors often take profits off the table
to safeguard future gains. This is a sensible decision sometimes. But
often, rising stock prices are just winning stocks taking a break before
274 FINANCIAL MODELLING

moving higher. You do not want to sell in this situation, but you do
want to lock in part of your profits. How is this accomplished?

There are several possible approaches. The most typical is to purchase

put options, which is a wager that the price of the underlying stock
will decrease. The put provides you with the choice to sell at a certain
price at a specific moment in the future, unlike shorting the stock.

Let us say you hold 100 shares of Company A, which has increased
Know More by 80% in only one year and is now trading at `100. Although you
Passive Strategies - Contrasting are certain of its bright future, you believe that the stock has grown
with active strategies, passive too rapidly and will probably lose value shortly. You purchase a single
strategies monitor weighted put option from Company A with a strike price of `105, or just in the
indexes in the market. Believing
in the way the market flows, money, with an expiry date six months in the future to secure your
investors believe that markets gains. You may purchase this option for `600 or `6 per share, entitling
are efficient. you to sell 100 shares of Company A for `105 at any point before the
option’s expiration in six months.

S
The price to purchase the put option will have increased dramatically
if the stock falls to `90. To make up for the drop in the stock price, you
now sell the option for a profit. Long-term Equity Anticipation Secu-
IM
rities (LEAPS) with durations as long as three years are available to
investors seeking longer-term protection.

It is crucial to keep in mind that you’re primarily concerned with pre-

venting losses from occurring rather than necessarily wanting to ben-
efit from the options. Investors may purchase index LEAPS, which
function similarly if they want to cover their whole portfolio rather
M

than a specific stock.

4. STOP LOSSES
N

Stop-loss orders shield investors from declining share prices. 5 Stops

come in a variety of forms that you might use. Hard stops include
causing the selling of a stock at a constant set price. For instance, if
you purchase shares of Company A for `10 each with a hard stop of `9,
the stock will be instantly sold if the price falls to `9.

Different from other stops, a trailing stop may be set in terms of dol-
lars or percentages and goes along with the stock price. Let us say you
establish a 10% trailing stop using the prior example. The trailing stop
will increase from the initial `9 to `10.80 if the price gains `2. You will
continue to hold the shares even if the price drops to `10.50 utilising
a hard stop of `9. If a trailing stop is used, your shares will be sold at
a price of `10.80. Which is better depends on what occurs next. The
trailing stop comes out on top of the stock price eventually falling to `9
from `10.50. The hard halt, though, is the best option if it rises above
`15.

Stop-loss advocates contend that they shield you from quickly shifting
market conditions. Hard stops and trailing stops, according to their
 PORTFOLIO MANAGEMENT 275

critics, both make transitory losses permanent. Stops of any type must
be carefully scheduled because of this.

5. DIVIDENDS

The least well-known method of safeguarding your money is probably

investing in dividend-paying equities. In the past, dividends have con-
tributed significantly to the overall performance of a company. It may
sometimes stand in for the total sum.

The best way to get profits that are above average is to own depend-
able businesses that pay dividends. Studies have demonstrated that Know More
firms that pay significant dividends tend to expand profits quicker Aggressive Strategies - As you
than those that do not, in addition to the investment income. Bigger may be able to tell by the name,
share prices, which in turn provide higher capital profits, are often a these strategies are used by
result of faster growth. extreme risk-takers. The aim
of this strategy is to maximise
How does this safeguard your portfolio, then? In essence, by boosting profits by taking a lot of risks.

S
your total return. Dividends provide a safety net for risk-averse inves-
tors during periods of decreasing stock prices, which often reduces
volatility.
IM
Dividends are a useful inflation hedge in addition to acting as a cush-
ion in a down market. You may provide your portfolio protection that
fixed-income investments, except Treasury Inflation-Protected Secu-
rities (TIPS), cannot match by investing in blue-chip corporations
that both pay dividends and have pricing power.
M

Additionally, if you invest in “dividend aristocrats,” or businesses that

have increased their dividends for 25 years running, you can almost
certainly count on them to do so even when bond payments stay the
same. The last thing you need as you approach retirement is for a
N

period of strong inflation to deplete your buying power.

6. PRINCIPAL-PROTECTED NOTES

Principal-protected notes with equity participation rights can be an

option for investors who are concerned about keeping their principal
intact. Similar to bonds, these are fixed-income investments that will
return your principal investment if you hold them until maturity. The
equity participation that goes along with the main guarantee is where
they diverge.

Let us imagine, for instance, that you want to purchase `1,000 worth
of principal-protected notes linked to the S&P 500. In five years, these
sounds will become mature. The issuer would pay less than face value
for zero-coupon bonds that mature around the same time as the notes.
Until they are redeemed at face value at maturity, the bonds would
not pay any interest. In this instance, `800 is spent on the `1,000 in
zero-coupon bonds, with the remaining `200 going toward S&P 500
call options.
276 FINANCIAL MODELLING

Earnings would be distributed when the bonds matured based on the

NOTE participation rate. If the index rose by 20% over the course of this time
Defensive Strategies - period and participation rates were 90%, you would receive your ini-
Conservative in their approach tial investment of `1,000 plus earnings of `180. Otherwise, you would
to investment, these strategies
lose `20 in earnings. However, let’s say the index declines 20% over
are employed by investors who
are very careful when they five years, you would still receive your initial `1,000 investment back
invest in the stock market. They but an investment directly in the index would be down by `200.
study trends in the market and
do a strong technical analysis Principal-protected notes will be appealing to risk-averse investors.
before formalising a portfolio. But before you get on board, you should research the creditworthi-
Such investors are averse to
ness of the bank guaranteeing the principal, the nature of the notes’
risk, but don’t mind a fairly good
rerun on investment. underlying investment and the costs involved in purchasing them.

SELF ASSESSMENT QUESTIONS

5. Which of the following is one of the tenets of Modern Portfolio

Theory (MPT)?

S
a. Stop Losses
b. Put Options
IM
c. Non-Correlating Assets
d. Diversification
6. Systematic risk, or the risk connected with investing in
the markets generally, is the reverse of unsystematic risk.
Which of the following options is correct regarding the above
M

statement?
a. Non-correlating assets
b. Out options
N

c. Diversification
d. Stop losses

ACTIVITY

Identify few portfolio strategies of leading investors across globe.

8.6 BUILDING AN INVESTMENT PORTFOLIO

Those who are just starting their investing journey may find the pro-
cess of building an investment portfolio overwhelming. Budgeting
for numerous bills including rent, Equivalent Monthly Instalments
(EMIs) for automobiles and other commitments might make it diffi-
cult to put aside enough money each month. But the sooner you start
investing, the more time your portfolio has to develop and expand.
NOTE
The asset allocation decision
refers to the allocation of
portfolio assets to broad asset
markets; in other words, how
much of the portfolio’s funds are
to be invested in stocks, how
much in bonds, money market
assets, and so forth.
278 FINANCIAL MODELLING

assets such as market securities or bonds must be used to offset the

NOTE risks of investing in high-growth companies to get the best returns.
Each investor must determine
which of these major categories Following is the example of the portfolio return in figure 8.2
of investments is suitable for
him/her. The next step, as
discussed in the preceding
section on asset allocation, is to
determine which percentage of
total investable assets should
be allocated to each category
deemed appropriate. Only then
should individual securities be
considered within each asset
class.

Figure 8.2 Portfolio return

SELF ASSESSMENT QUESTIONS

S
7. Investing in a variety of assets, such as stocks, bonds,
government securities, real estate, commodities and cash, is
the first rule of portfolio construction. Which of the following
IM
options is correct regarding the above statement?
a. Financial goals
b. Investment horizon
c. Risk tolerance
M

d. Asset allocation
8. Assets that will mature in time for your short-, mid- and long-
term objectives should be in your portfolio. Which of the
following options is correct regarding the above statement?
N

a. Investment Horizon
b. Risk Tolerance
c. Risk Diversification
d. None of these

ACTIVITY

How investment portfolio is useful for the growth of the firm.

RISK REDUCTION IN THE STOCK

8.7
PORTION OF A PORTFOLIO
It is time to start investing after you have paid off all of your high-in-
terest personal debt, including any credit card debt and established
an emergency fund.
 Know More
Assume that every risk factor
in a security portfolio is
independent. This portfolio’s
exposure to any one source
of risk decreases when more
securities are added to it. The
law of big numbers states that
the likelihood that the sample
mean will be relatively near
to the population’s predicted
value increases with sample
size. The insurance principle, so
named because it holds that an
insurance firm decreases its risk
by issuing numerous policies
against many separate sources
of risk, can be thought of as
risk reduction in the case of
independent risk sources.
 PORTFOLIO MANAGEMENT 281

A passively managed index fund, on the other hand, just replicates a

stock index, such as the Russell 2000 or the 500. Additionally, no work
is needed from compensated fund managers.

As a result, these index funds have much lower expense ratios, some-
times one-tenth or one-twelfth of what actively managed funds charge.
This allows you to invest more of your money, which will grow over
time.

3. DIVERSIFICATION ACROSS MARKET CAPS

Diversification, or placing your metaphorical eggs in more than one

basket, is a popular strategy for lowering risk. And among the several
types of diversification, market cap diversification is one.

The entire value of all publicly traded shares for a certain firm is
referred to as market capitalisation. To put it simply, a company’s mar-
ket capitalisation (market cap) is `500,000 if it has 100,000 outstanding
shares and a share price of `5.

S
This is one alternative to using the number of workers to describe a
company’s size. After all, businesses with fewer people may neverthe-
IM
less generate millions of dollars in revenue annually and have a high
market value, but businesses with more employees may see little to
no profit.

On the other hand, small-cap businesses often have far lower profit-
ability and staff counts than large-cap businesses. The stock prices of
M

large-cap businesses also tend to be more stable, with slower growth

and a lesser danger of a price crash.

Smaller businesses have more potential to expand and may swiftly

increase in value. However, they are also just as swift to fall.
N

You may balance the stability of large-cap firms with the potential
development of small-cap companies by distributing your assets
across small-, mid- and large-cap index funds. For instance, the Rus-
sell 2000 represents 2000 smaller-cap U.S. firms, whereas the S&P 500
represents 500 of the biggest U.S. corporations. To target certain mar-
ket size and area, you may invest in index funds that resemble these
indices (such as the one stated above, SWPPX), as well as any other
index worldwide.

4. DIVERSIFICATION ACROSS REGIONS

Investors may distribute risk across various market capitalisations, as

well as among various geographical areas and nations.

As developed economies, the U.S. and European markets often do not

expand as swiftly as developing markets. Emerging countries with
economies attempting to catch up to advanced nations such as Japan
282 FINANCIAL MODELLING

and the U.S., such as Brazil or Vietnam, have the opportunity for rapid
expansion. They may, however, also fall apart fast as a result of politi-
cal unrest or financial crises.

Similar to market caps, dividing money across funds active in several

locations will allow you to strike a balance between risk and growth.
I strive for a 50/50 split of domestic and foreign capital, but there is
no foolproof formula for success. Generally speaking, the potential for
development and the danger of rapid losses increases with the econo-
mies of the places where you invest being less developed.

5. DIVERSIFICATION ACROSS SECTORS

Some industries tend to have larger risks and potential rewards than
others, just as some locations may see quicker growth or losses.

For instance, the technology industry often experiences phenomenal

S
growth. Look no further than the 78% fall of the tech-heavy NASDAQ
index from 2000 to 2002 to see examples of its horrific disasters.

In comparison, some industries seem to be far more stable. Consider

IM
utility stocks as a prime example of a “defensive” investment sec-
tor—a haven when other industries start to seem unstable and dan-
gerous. Everyone still needs power, after all, regardless of the state of
the economy.
M

6. REAL ESTATE INVESTMENT TRUST (REITS)

Purchasing real estate investment trusts or REITs is an additional

method of stock portfolio diversification.
N

A REIT is a firm that invests in real estate or real estate-related ser-

vices, but they are traded on the stock market as stocks and ETFs
(such as mortgage REITs). Investors may indirectly participate in real
estate in this manner without having to learn how to flip homes or
how to manage a rental property.

Keep in mind that the stock market and the real estate market often
move in separate directions. Although both the housing and stock
markets crashed during the Great Recession, this was not always the
case. Investors may further diversify their portfolios by placing money
in both stock indices and real estate-related ventures.

7. BOND FUNDS

Similar to this, investors may purchase bonds on the stock market by

purchasing funds that do so. For instance, the Vanguard Total Bond
Market Index Fund (VBMFX) from Vanguard invests in around 70%
U.S. business bonds and 30% U.S. government bonds.
 PORTFOLIO MANAGEMENT 283

Bonds are known for being low-risk and low-return investments that
help balance a portfolio of risky stocks. Of course, if you prefer, you
can decide to invest in high-risk, high-return bond funds.

As you get closer to retirement, think about using bond funds as a tool
to reduce the risk associated with the sequence of returns.

8. ONLY SPECULATE WITH MONEY YOU CAN AFFORD TO LOSE

An investment involves purchasing an index fund that closely resem-

bles the Russell 2000, such as the Vanguard Russell 2000 ETF (VTWO).
It essentially enables you to own shares in 2000 firms, the majority of
which are expanding and profitable. Additionally, you may examine
decades of history to support your investment decision.

Early in your financial career, educate yourself on the differences

between investing and speculating. A generally steady, verifiable and

S
quantifiable asset is what investing entails while speculating is taking
a high-risk wager in exchange for the chance of huge rewards.

Take two real estate ventures as yet another illustration. Investing

IM
involves purchasing a rental property that is already occupied by a
dependable tenant and can be inspected, its price compared to similar
properties, its current rent compared to adjacent market rates and its
cash flow projected. As an alternative, speculating is purchasing an
inexpensive plot of property in the hopes that it may one day become
very valuable.
M

Speculating is not always a bad thing. A lot of early investors who

purchased bitcoin or other cryptocurrencies gained incredible sums
of money. However, the secret to risk management is to only speculate
with money you’re willing to lose.
N

By all means, save 1%, 5% or 10% of your portfolio for high-risk, specu-
lative investments — securities you purchase “just for fun,” which
may see their value plummet or soar.

Just be sure that if they do fail, you will not be brought to ruin along
with them.

9. REINVEST DIVIDENDS

When you purchase a stock or fund, you may opt to reinvest dividends
to help compound your investment returns. Reinvesting dividends
may also assist you to avoid opportunity costs and losses from infla-
tion, as opposed to letting the money accumulate in your brokerage
account as cash.

In addition, it aids in your efforts to save it. Dollar-cost averaging can

also take the form of reinvested dividends. Whenever dividends are
284 FINANCIAL MODELLING

paid out, they are immediately reinvested in the purchase of further

shares of the fund at the current share price.

10. MAKE DEFENSIVE MOVES BEFORE A CRASH

You should not feel compelled to leave your money in high-risk indus-
tries or areas if you are a worried investor and begin tossing and
turning over reports of an impending crisis. Put money in defensive
sectors, bonds, precious metals or, if you are feeling nervous while
equities prices are still high, you may just sit on big sums of cash.

Just remember not to sell everything when the market has already
plummeted out of fear.

11. THINK TWICE BEFORE SELLING DURING CORRECTIONS

Of course, the issue is that the majority of investors do not begin to

S
worry until the market decline is already well underway.

You have made investments in fundamentally good funds that will

recover if you have adhered to the other risk-mitigation strategies on
IM
this list. Investors get into problems when they sell after a market col-
lapse and at a loss, then timidly hold off on repurchasing until the
recovery is well underway.

They are so purchasing at a premium.

When everyone around you is in a panic, that is when you should pur-
M

chase instead of sell. If you’re using dollar cost averaging, stick with
your plan and keep purchasing to bring down your average per-share
base price.
N

Your speculative investments are the exception to this rule; if you

can see the writing on the wall with them, you should sell and deduct
your losses. Also keep in mind that you are just speculating with “fun
money,” so no matter what happens, you will not lose everything.

12. HIRE AN EXPERT (OCCASIONALLY)

The risk-reducing investment techniques described above are

designed to be easy enough for anybody to use without professional
assistance. But it does not imply that you should never ask a profes-
sional for help.

Financial aspirations and circumstances vary from person to person.

To gain feedback, discuss ideas and ensure you’re on the right track, it
might be helpful to meet for an hour or two now and then with a qual-
ified financial planner. Even though a lot of financial planners may
want to upsell you on a recurring service plan, you can start by only
paying them for the hour for a single consultation.
 PORTFOLIO MANAGEMENT 285

Hiring an investment adviser on an hourly basis will provide you with

more detailed recommendations on what to invest in. Make it clear
before the meeting that you want a one-time session for individualised
counsel to avoid sales pitches for their continued services.

RISKS INVOLVED IN INVESTMENT PORTFOLIO BUILDING

Any investment has some level of risk. Even the most reliable asset
could have an unanticipated setback. Sovereign risk, principal loss
risk and inflation risk are the three main categories into which portfo-
lio risks may be classified.

When a government or nation is unable or unwilling to honour its obli-

gations or loan arrangements, sovereign hazards arise. This might put
safe assets like government securities in danger.

Loss of primary refers to the possibility of losing all or a portion of the

S
investor’s initial investment. To reduce the danger of principle loss,
many cautious investors choose to invest in low-risk securities. It’s
crucial to realise that every asset has this particular danger.
IM
The possibility that an investment portfolio’s returns would fall short
of its anticipated value owing to inflation is known as an inflation risk.
It affects the rate of actual returns on an investor’s assets and is most
often related to bonds and fixed income products.

MINIMISING PORTFOLIO RISKS

M

A portfolio will always include risks. In order to reduce an investor’s

exposure to risks via risk diversification, wise investing emphasises
risk management. It is regarded as the best tactic for managing all
N

three risk categories.

By making sure that your portfolio doesn’t rely primarily on govern-

ment assets for stability, you may reduce your exposure to sovereign
risks. While bonds and mutual funds are designed to balance the like-
lihood of principal loss, diversifying into equities also reduces the dan-
ger of inflation. Investors must simultaneously watch for changes in
the market. Stop-loss orders are one kind of strategy that is used to
reduce losses when they are inevitable.

The regular evaluation and rebalancing of a portfolio is another cru-

cial component of risk management. Depending on your age, income
and circumstances, your risk tolerance may alter over time. For
instance, you won’t be as eager to take chances when you have kids or
are getting close to retirement. It’s critical to analyse your portfolio to
discover how much of it is made up of low-risk, low-return assets like
bonds or fixed-income securities and high-risk, high-return invest-
ments like equities.
286 FINANCIAL MODELLING

To monitor your assets and the annual development of your portfo-

lio, frequent reviews are also required. With time, you may develop a
more in-depth understanding of how your portfolio behaves and the
best ways to enhance it. But more crucially, it guarantees that your
portfolio adapts to your shifting needs.

SELF ASSESSMENT QUESTIONS

9. Investor fees are higher for these products since the fund
manager actively manages them to outperform the typical
market returns. Which of the following options is correct
regarding the above statement?
a. Diversification across sectors
b. Diversification across regions
c. Dollar-cost averaging

S
d. Index funds
10. Which of the following is an additional method of stock
portfolio diversification?
IM
a. REITs
b. Bond funds
c. Both a. and b.
d. None of these
M

ACTIVITY

Find out the advantages of the stock portion.

N

8.8 VALUE INVESTING

Value investing is a kind of investing that makes money by finding
NOTE undervalued stocks. The foundation of it is the notion that each stock
Value investing style of investing has an intrinsic value, or what it is worth.
termed as conservative
investing. In the case of value You may ascertain what this inherent worth of a firm is by performing
investing, bargains are often a fundamental study on it. Buying stocks that sell for a sizable dis-
measured in terms of market
prices that are below the
count to their inherent worth is the goal of value investing (i.e., they
estimated current economic are cheaper than their true value). Once you purchase a cheap stock,
value of tangible and intangible the price of the stock ultimately increases to its intrinsic value, gener-
assets. ating a profit for us.

Choosing stocks that appear to be trading for less than their intrinsic
or book worth is part of the value investing technique. Value investors
hunt out stocks that they believe the stock market is undervaluing.
They contend that the market overreacts to both positive and nega-
tive news, causing stock price fluctuations that are inconsistent with
 PORTFOLIO MANAGEMENT 287

a company’s long-term fundamentals. The overreaction presents a

chance to make money by purchasing equities at a discount—on sale.

The most well-known value investor today is arguably Warren Buffett,

but there are many others as well, including Seth Klarman, a mul-
tibillionaire hedge fund manager, David Dodd, Charlie Munger and
another Graham pupil, Christopher Browne.

The fundamental idea of daily value investing is simple: If you know

the real worth of something, you may save a lot of money when you
purchase it at a discount. Most people would concur that you receive
the same TV with the same screen size and picture quality whether
you get a new TV on sale or at full price.

Similar to how stocks operate, a company’s stock price may fluctuate

even if its value or valuation has not changed. Similar to TVs, stocks Know More
experience periods of high and low demand, which causes price vola- Shares are purchased by value
tility, but this does not affect the value you receive for your investment. investors at enticingly low

S
Value investors believe that stocks behave similarly to smart consum-
ers who would say that it makes no sense to buy full price for a TV
because TVs go on sale frequently throughout the year. Naturally,
prices. They are distinguished
by keeping a portfolio of assets
such as real estate, machinery,
other financial stakes in
IM
subsidiaries or other businesses,
unlike televisions, stocks will not be on sale during cyclical periods and market underperformers.
such as Black Friday and their discount pricing will not be publicised. Deep-value investors are value
investors who exclusively
Value investing is the practice of conducting research to identify these choose inexpensive, seldom
traded shares.
covert stock sales and purchasing them at a discount from their mar-
M

ket value. Investors may receive hefty payouts for long-term purchases
and holdings of certain value equities.

SELF ASSESSMENT QUESTIONS

N

11. Which of the following is a kind of investing that makes money

by finding undervalued stocks?
a. Growth investing
b. Investment risk pyramid
c. Building an investment portfolio
d. Value investing

ACTIVITY

Write a short note on the advantages of value investing.

8.9 GROWTH INVESTING

Growing an investor’s money is the main goal of the investment style
and technique known as growth investing. Growth stocks, or young or
tiny businesses whose profits are anticipated to expand at an above-av-
288 FINANCIAL MODELLING

erage pace relative to their industry sector or the broader market, are
the type of securities that growth investors often invest in.

Many investors find growth investing to be very appealing since pur-

chasing shares in developing firms may result in substantial profits (as
long as the companies are successful). But because they have not been
tested, these businesses frequently carry a significant level of risk.

Value investment and growth investing can be compared. Choosing

stocks that appear to be trading for less than their intrinsic or book
worth is part of the value investing technique.

Growth investors often seek investments in fast developing areas (or

even whole industries) that are home to emerging products and ser-
vices. Profits from capital appreciation, or the gains they will obtain
when they sell their shares, are sought after by growth investors (as
opposed to dividends they receive while they own it). In reality, rather

S
than providing dividends to its shareholders, the majority of growth-
stock businesses reinvest their profits back into the company.

These businesses often have great promise but are tiny and young.
IM
They can also be new public corporations that have recently begun
trading. The underlying assumption is that as the business grows
and prospers, better earnings or revenues would ultimately result in
higher stock values. Therefore, growth stocks may trade with a high
Price-to-Earnings (P/E) ratio. They might not be making money right
now, but they should in the future. This is due to the possibility that
M

they possess patents or have access to technology that provides them

with an advantage over rivals in their field. They reinvest the money
to create even more cutting-edge technology to stay one step ahead of
rivals and they pursue patents to guarantee longer-term growth.
N

Since investors strive to maximise their capital returns, growth

NOTE investing is also frequently referred to as a capital growth strategy or
Growth investors consider a capital appreciation approach. It is important to first comprehend
several factors to identify what growth investing is and is not. The strategy involves purchas-
superior performing securities ing stocks linked to companies that possess desirable qualities that
for purchase. Some of the
factors that are looked into
their competitors do not. These may include items that are simple to
are short run and long run high measure, including sales and/or earnings growth rates that outper-
growth rates from sales and form the market. They can also contain higher-quality elements such
EPS, high profit margin and as solid client loyalty, a valued brand.
notable increase in projected
earnings for both three and five Growth stocks frequently occupy attractive positions in developing
years.
industrial areas with wide lanes for future growth. A growth stock is
valued at a premium that represents the confidence investors have
in the firm due to the attractive future and the exceptionally great
performance the business has had recently. As a result, the easiest
method to tell if a stock is a growth stock is to see if its valuation, typi-
cally measured by its price-to-earnings ratio, is high in comparison to
the overall market and its competitors in the same sector.
 PORTFOLIO MANAGEMENT 289

This strategy is in contrast to value investing, which concentrates on

stocks that have lost Wall Street favour. These equities have lower
values, which correspond to more pessimistic sales and profit projec-
tions. Both investment approaches can be successful if used consis-
tently, but most investors favour one approach over the other.

Now that you are aware that growth investing is suited to you, let us
examine the procedures for maximising the technique.

STEP 1: PREPARE YOUR FINANCES

As a general guideline, you should not invest in stocks with funds that
you anticipate using within the next five years, at the very least. That
is because, despite the market’s long-term tendency to increase, it reg-
ularly experiences abrupt declines of 10%, 20% or more. Setting your-
self up to be compelled to sell stocks during one of these downturns is
one of the worst blunders an investor can make. Instead, you should

S
be prepared to purchase equities when most people are selling them.

STEP 2: GET COMFORTABLE WITH GROWTH APPROACHES

IM
As you go forward with building up your funds, it is essential to equip
yourself with yet another potent tool: education. You may opt to use a
variety of growth investment techniques, after all.

For instance, you could limit your search to big, established companies
with a track record of making money. Your strategy may be based on
M

quantitative indicators such as operating margin, return on invested

capital and compound annual growth that are compatible with stock
screeners. However, many growth investors place less emphasis on
share prices and instead want to invest in the best-performing compa-
nies, as seen by their constant increases in market share.
N

It frequently makes sense to concentrate your purchasing on markets

and businesses you are particularly familiar with. Having expertise in,
for instance, the restaurant industry or working for a company that
provides cloud software services may help you assess investments as
prospective buy prospects. Knowing a lot about a select group of firms
is typically superior to knowing little to nothing about a diverse range
of enterprises.

But if you want to maximise your profits, you must consistently imple-
ment the plan you decide on and resist the urge to switch to a different
strategy just because the current one appears to be more effective.
That technique is called “chasing returns,” and it’s a proven way to
underperform the market over the long run.

Learn the principles of this stock market investment technique to

avoid that destiny. Reading a few classic growths investing books is a
terrific place to start, and then educate yourself with the professionals
in the area.
290 FINANCIAL MODELLING

T. Rowe Price, for instance, is recognised as the originator of growth

investing and even though he left the industry in 1971, his impact can
still be seen today. At a period when equities were viewed as cyclical,
short-term investments, Price helped popularise the concept that a
company’s profits growth could be projected out over several years.

Although Warren Buffett is typically thought of as a value investor,

several aspects of his strategy are growth-oriented. Buffett once said,
“It’s far better to purchase a fabulous firm at a fair price than a fair
company at a wonderful price.” This is a famous expression of philos-
ophy. In other words, while the price is a crucial component of any
investment, the strength of the company may be equally as significant
as or even more so.

STEP 3: STOCK SELECTION

It’s time to get ready to start investing right away. Choosing the exact

S
amount of money you want to put toward your development investing
plan is the first step in this process. It can make sense to start modest
with, say, 10% of the assets in your portfolio if you’re brand-new to the
strategy. This percentage may increase as you become more accus-
IM
tomed to the volatility and gain experience investing through various
market conditions (rallies, slumps and everything in between).

Risk also plays a significant factor in this decision since growth equi-
ties are viewed as being more aggressive and volatile than defen-
sive stocks. Because of this, a longer time horizon typically gives you
M

greater freedom to skew your portfolio in favour of this investment

approach. If your portfolio gives you anxiety, that may be a sign that
your growth stock allocation is too high. Reduce your exposure to
specific growth stocks in favour of more varied choices if you start to
worry about future losses or previous market declines.
N

SELF ASSESSMENT QUESTIONS

12. Choosing the exact amount of money you want to put toward
your development investing plan is the first step in this
process. Which of the following options is correct regarding
the above statement?
a. Get comfortable with growth approaches
b. Prepare your finances
c. Stock selection
d. None of these

ACTIVITY

Find out the disadvantages of growth investing.

S
 PORTFOLIO MANAGEMENT 293

c. Base
d. Both a. and b.
5. Which of the following orders shield investors from declining
share prices?
a. Put options
b. Stop loss
c. Dividends
d. None of these
6. Which of the following with equity participation rights can be
an option for investors who are concerned about keeping their
principal intact?
a. Principal-protected notes
b. Dividends
c. Put options
d. Diversification
S
IM
7. Which of the following is the amount of risk you can tolerate,
and it is influenced by your income, spending and risk-taking
propensity?
a. Risk diversification
b. Risk tolerance
M

c. Investment horizon
d. None of these
8. Which of the following are known for being low-risk and low-
N

return investments that help balance a portfolio of risky stocks?

a. Index funds
b. Bonds
c. REITs
d. None of these
9. Growing an investor’s money is the main goal of the investment
style and technique known as
a. Building an Investment Portfolio
b. Value investing
c. Growth investing
d. Investment risk pyramid
10. As a general guideline, you should not invest in stocks with funds
that you anticipate using within the next five years, at the very
294 FINANCIAL MODELLING

least. Which of the following options is correct regarding the

above statement?
a. Get comfortable with growth approaches
b. Prepare your finances
c. Stock selection
d. None of these

8.12 DESCRIPTIVE QUESTIONS

? 1. What do you mean by portfolio management?
2. Discuss the value investing.
3. Describe the concept of growth investing.

HIGHER ORDER THINKING SKILLS

8.13
S
(HOTS) QUESTIONS
1. Which of these is a wager on an unknown future to potentially
win money?
IM
a. Investment
b. Gambling
c. Financing
d. Portfolio
M

2. Which of the following is a technique used to assess a security’s

value by looking at its financial information?
a. Security analysis
N

b. Fundamental analysis
c. Performance analysis
d. None of these
3. Which of the following describes typical mistakes in managing
investments?
a. Not having a clearly defined investment plan
b. Investors often overdose themselves on information
c. Both a. and b.
d. None of these
4. Which of the following characteristics is necessary for a wise
investor?
a. Smart investor invest consistency
b. Smart investors are important
 PORTFOLIO MANAGEMENT 295

c. Smart Investors are emotionally tied to their investment po-

sition
d. All of these

8.14 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Turning Your Goals into a Strategy 1. a. Strategy
Risk-reward Ratio 2. c. Risk-reward Ratio
Investment Risk Pyramid 3. d. Investing risk pyramid
4. c. Base
Portfolio Strategies 5. d. Diversification
6. a. Non-correlating assets
Building an Investment Portfolio

Risk Reduction in the Stock Por-

7.
8.
9.
d.

S
Asset allocation
a. Investment Horizon
d. Index Funds
IM
tion of a Portfolio
10. a. REITs
Value Investing 11. d. Value Investing
Growth Investing 12. c. Stock Selection
M

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. b. Investment Objectives
N

2. b. Traders
3. c. Middle
4. c. Base
5. b. Stop loss
6. a. Principal-protected notes
7. b. Risk Tolerance
8. b. Top
9. c. Growth Investing
10. b. Prepare your Finances

HINTS FOR DESCRIPTIVE QUESTIONS

1. The process of choosing and managing a set of investments
to fulfil the long-term financial goals and risk tolerance of a
customer, a business or an institution is known as portfolio
management. Refer to Section 8.1 Introduction
 C H A
9 P T E R

INTEGRATED RISK MODELLING

CONTENTS

9.1 Introduction
9.2

S
Meaning of Risk Modelling
Self Assessment Questions
Activity
IM
9.3 The Model
9.3.1 General Risk
9.3.2 Credit Risk
9.3.2 Operational Risk
9.3.3 Market Risk
M

Self Assessment Questions

Activity
9.4 Implementation
9.4.1 Simulation Procedure
N

9.4.2 Simulation Variability

Self Assessment Questions
Activity
9.5 Empirical Results
Self Assessment Questions
Activity
9.6 Summary
9.7 Multiple Choice Questions
9.8 Descriptive Questions
9.9 Higher Order Thinking Skills (HOTS) Questions
9.10 Answers and Hints
9.11 Suggested Readings & References
 Case Objective
This caselet discusses why
organisations need integrated
risk management.
 INTEGRATED RISK MODELLING 299

INTRODUCTORY CASELET

Integrating the risk modelling procedures will expand the market

and boost the likelihood of success. A programme for integrated
risk modelling is also required for an organisation to succeed in a
global economy.

S
IM
M
N
300 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

> Discuss the meaning of risk modelling
> Explain the concept of general risk
> Classify operational risks
> Describe the simulation procedure
> Express simulation variability
> Discuss empirical results

9.1 INTRODUCTION

Quick Revision
In the previous chapter, you studied about portfolio management. The
process of choosing and managing a set of investments to fulfil the

S
long-term financial goals and risk tolerance of a customer, a business
or an institution is known as portfolio management. While people
have the option to create and manage their portfolios, professional
portfolio managers act on behalf of customers. The ultimate objective
IM
of the portfolio manager is to maximise the projected return on the
assets while maintaining a reasonable degree of risk exposure.

Security and risk requirements for an information system, or the pro-

cess of designing such a system, are typically mapped out in security
and risk models. It is also used to predict and model the behaviour of
M

such systems in order to understand the specifics of changes that are

expected to take place when the system is operating.

In some industries, including financial services and energy, where

taking measured risk is essential to the business, risk modelling has
N

been common for years. A wide range of risk models and simulations
have lately started to be adopted by companies in both the public and
private sectors in order to begin tackling strategic, operational, com-
pliance, geopolitical and other sorts of risk.

Many different types of risk can be assessed using risk models. Under-
standing the risk associated with attaining broad strategic objectives
or providing highly detailed answers may be desirable. Perhaps you
want to assess the geopolitical risks of joining a developing market or
comprehend how an adaptable opponent (such a hacker or terrorist)
can strike you. Once risk models have been created, they can be used
to assess a system’s behaviour in both real-world situations and specu-
lative “what if” scenarios. This aids organisations in assessing their
level of risk tolerance and how to make their systems more resilient so
they can endure a variety of shocks.

The notion that risk models are innately very expensive and take
months or even years to construct is a widespread one. In a matter of
 INTEGRATED RISK MODELLING 301

weeks to a few months, with the aid of numerous new tools and accel-
erators, it is now possible to build even pretty sophisticated models.
In this chapter, you will study the meaning of risk modelling, credit
risk, operational risk, market, risk, simulation procedure, simulation
variability empirical results, etc., in detail.

9.2 MEANING OF RISK MODELLING

Risk modelling is the systematic and holistic approach to risk manage-
ment, especially compared to more traditional methods, such as only
buying insurance to protect your business. Risk modelling is about
creating effective risk analyses, magnifying how efficient insurance
can be, and taking a more comprehensive approach to risk research
and solutions.

Risk modelling is about modelling and quantifying risk. For the finan-
cial sector, credit risk cases are specifically essential for quantifying

S
potential losses. Operational risk or the quantification of potential
losses due to process errors, is a relevant topic for all forms of organ-
isations. The approach to risk modelling pays particular attention
IM
to systemic risk in complex systems. Recent topics covered include
operational risk analysis, with particular attention to process inter-
dependencies, and credit risk analysis in interdependent corporate
portfolios. Risk modelling explains the intermittent nature of market
dynamics in terms of interacting prices.
M

The situations of credit risk estimating possible losses due to, for
example, debtor bankruptcy or market risk quantifying potential
losses owing to adverse movements of a portfolio’s market value is
of special significance to the financial sector. Operational risk, which
involves estimating possible losses brought on by failed procedures, is
N

a pertinent problem for every kind of firm.

A systemic risk in complex systems is given special consideration in

the approach to risk modelling. The study of operational risks, with a Know More
focus on the interdependence of processes, and the analysis of credit Risk modeling uses a variety
risks in portfolios involving mutually dependent enterprises are con- of techniques including
temporary topics you have looked at and it also put forward models market risk, value at risk (VaR),
that use interacting prices to explain how market dynamics are spo- historical simulation (HS), or
extreme value theory (EVT) in
radic. order to analyse a portfolio and
make forecasts of the likely
The large-scale blackouts that affected the northeastern US and losses that would be incurred
parts of Canada in August 2003, as well as the significant blackouts for a variety of risks.
in London, Denmark and the southern part of Sweden, as well as a
nationwide one in Italy in the same month, serve as rather spectacu-
lar recent examples illustrative of the predictions regarding the pos-
sibility of first-order phase transitions to a catastrophic breakdown in
systems of interacting processes.
302 FINANCIAL MODELLING

SELF ASSESSMENT QUESTIONS

1. Which of the following goal is to predict and quantify risk?

a. Risk modelling
b. Implementation
c. Empirical results
d. None of these
2. Which of the following in complex systems is given special
consideration in the approach to risk modelling?
a. Operational risk
b. Credit risk
c. Systemic risk
d. Market risk

S
ACTIVITY
IM
Write some advantages of risk modelling.

9.3 THE MODEL

A model is a framework, quantitative method or strategy that is pred-
M

icated on hypotheses and uses mathematical, economic, statistical or

financial theories and methods. The model converts the supplied data
into a quantitative estimate.

Models are used by financial organisations and individuals to deter-

N

mine the hypothetical worth of stock prices and discover trading

opportunities. Models can be helpful tools for investment research,
but they can also be vulnerable to several risks, including the use of
faulty data, programming mistakes, technological faults and incorrect
interpretation of the model’s conclusions.

9.3.1 GENERAL RISK

Know More
The goal of risk modeling is The combination of a wide range of hazards is one of the key tech-
to predict and quantify risk. nological challenges in risk management for a financial institution. A
The situations of credit risk
estimating possible losses
financial institution’s annualised loss total is T.
due to, for example, debtor
bankruptcy or market risk T=C+O+M (1)
quantifying potential losses
owing to adverse movements Where C, O and M represent the annual losses brought on by credit,
of a portfolio’s market value are operational and market risk, respectively. Typically, the risk manager
of special significance to the
financial sector.
is concerned with the combined distribution or the distribution of all
hazards together and has some knowledge of the marginal distribution
 INTEGRATED RISK MODELLING 303

of each risk category. Technically, aggregating these hazards is fairly

difficult. It is important to do a numerical integration or simulation to
convolve the underlying risk distributions for each risk category since
they do not all necessarily follow the same distributional pattern.

There are not many methods in the literature for combining credit,
market and operational risk. Under risk modelling all hazards are
assumed to be jointly normally distributed, which greatly simplifies
the method. The use of copulas to connect the marginal to the joint
distribution is another technique that has lately gained a lot of popu-
larity in finance.

Choosing a common time horizon for all the different risk categories
is another difficulty in integrated risk management. Usually, a market
risk is calculated daily. Both operational risk and credit risk are gen-
erally calibrated to one year. The practice for modelling risks are fol-
lowed and evaluating capital in banks, which is to employ a one-year

S
horizon. An institution may access the markets for additional capital
within a one-year time horizon, which is also the one, utilised in the
New Basel Accord. It also corresponds to the internal capital alloca-
IM
tion and budgeting cycle.

The simulation is utilised to convolve the marginal distributions in

terms of the aggregate of risk kinds. After taking samples of P’s simul-
taneous distributions C, O and M (C, O, M) it create the total loss T by
(1). The combined probability of the credit, market and operational
M

losses P (C, O, M), according to the multiplication law of probability

from conventional statistical theory, may be broken down as follows:

P (C, O, M ) = P (C) P (O|C) P (M |C, O). (2)

N

Due to its dominance in the financial organisation under consider-

ation, credit risk is chosen as the basic risk to which all other risk
categories are connected. Be aware that (2) does not mean that you
attempt to forecast the operational loss and market loss based on the
credit loss. (2) is clarified by assuming that:

P (M |C, O) = P (M |C), (3)

This demonstrates the conditional independence between market and

operational losses. In other words, once the credit loss is established,
no amount of operational loss proof alters the perception of the mar-
ket loss. Combining (3) and (2) results in:

P (C, O, M) = P (C) P (O|C) P (M |C). (4)

The combined distribution of risk categories will be able to determine

if you can simulate using the three probability distributions on the
right.
304 FINANCIAL MODELLING

9.3.2 CREDIT RISK

The risk of losses brought on by the inability of DnB’s financial coun-

NOTE terparties to fulfil their commitments is known as credit risk. The DnB
credit model currently in use, which is distinct from other credit risk
Credit risk is the possibility of a
loss resulting from a borrower’s systems but comparable to the methodology employed by Ward &
failure to repay a loan or meet Lee. The following may be used as a summary. First, 10 kinds of credit
contractual obligations. obligations are created depending on the likelihood of default. Both
financial and non-financial elements, such as management features,
are used to categorise obligations.

Estimating exposure, or how much would need to be paid back to the

bank in the event of a failure, is the next stage. Each commitment’s
estimated loss is determined by multiplying the projected default fre-
quency, exposure at default and loss ratio. The estimated loss for the
portfolio is then calculated by adding the obligations.

S
The risk level in the portfolio is influenced by how losses are distrib-
uted about one another. By assuming a link between each loan’s com-
mitment and the total credit losses, the credit model describes how
each loan affects the overall risk.
IM
It is feasible to calculate the credit portfolio’s standard deviation
based on these connections. In this scenario, the inputs and outputs
for the credit component of the overall risk are, respectively, produced
by DnB’s credit management systems.
M

The whole distribution is required, not just the mean and standard
deviation, to simulate the model. The credit loss rate R is used in the
DnB model, whereby is the institution’s overall credit loss C divided
by its entire exposure. It has decided to utilise a beta distribution to
represent the portfolio of linked loans, using the same logic as that
N

shown below.
The probability density of R is more specifically:
Γ(α + β ) α −1
b( r) = r (1 − r)β −1 , 0 < r < 1, (5)
Γ(α )Γ(β )

where, the Gamma function Γ (α) is defined by,

∞
Γ(α ) = ∫0
tα −1 e− t dt

for α > 0

The two parameters define the beta distribution. The following equa-
tions may be used to get these from the expectation µJ = µ/e and stan-
dard deviation σJ = σ/e of the loss ratio R.
2
 µ' 
α = (1 − µ ')   − µ '
σ ' 
 INTEGRATED RISK MODELLING 305

And

α
β= −α.
µ'

9.3.3 OPERATIONAL RISK

The operational risk of DnB originates from both direct and indirect
losses brought on by external occurrences like natural catastrophes
and criminal activity as well as internal causes like insufficient or inef-
ficient internal procedures and systems. Some of these losses happen
regularly but are only of little worth, whereas others happen very sel-
dom yet are extremely substantial.

Based on expert judgement and arbitrary decisions since the amount

and quality of DnB’s information on operational losses do not permit NOTE
the accurate calculation of the parameters in an EVT model. The size Operational risk summarises

S
of the most frequent loss, the risk-adjusted capital needed to cover
operational risk (here, the institution follows an international industry
benchmark, which has also been acknowledged by the Basel Commit-
the chances and uncertainties
a company faces in the course
of conducting its daily business
activities, procedures and
IM
tee and let operational risk represent around 20% of overall capital systems.
requirement) and the correlation between operational and credit risk
were three quantities on which the risk managers felt they had a rea-
sonably clear opinion. The latter is assumed to be true because opera-
tional mistakes related to credit activity often do not show up until the
credit risk manifests.
M

Risk-adjusted capital may be connected to the 99.97% quantile and

the operational loss distribution’s mode, m, respectively. The former
is connected to the evaluation of an S&P rating of “AA” for the insti-
N

tution, for instance equates to an average default chance of the insti-

tution of 0.03%. In light of this, a suitable distribution for operational
loss is heavy-tailed, defined by the mode and the 99.97% quantile and
that can be conveniently connected to the beta distribution for credit
risk. It was discovered that the lognormal distribution was a sensible
option.

One method recommended by the Basel Committee BIS is to simulate

the frequency of operational loss events over a year from a Poisson
distribution and the severity of these events from a lognormal distri-
bution, then add the individual events to calculate the annual operat-
ing loss as a whole. This method distributes the entire operating losses
as a sum of lognormal. It is a rough approximation to approximate this
distribution using another lognormal distribution.

By converting C and O to standard normal variables X and Y, defin-

ing a correlation between these variables and then re-transforming to
the appropriate distributions, it is possible to establish the connection
306 FINANCIAL MODELLING

between operational and credit losses. This phenomenon is known as

copula technique. Although a normal copula implies independence
(correlation breakdown) in the tails, this is farther out in the tail than
the 99.97% quantile that does not preclude it from being used in the
calculation of capital at risk because it is further out in the tail than
the 99.97% quantile. The correlation between C and O will be lower
using this method but this may be made up for by increasing the cor-
relation between X and Y.

The modelling is broken out as follows. The credit loss C represented

in 9.3.1 Credit Risk

C = e B−1{Φ(X)} (6)

When X is a standard normal variable, Φ (.) is the cumulative standard

normal distribution function, and B−1 (.) is the inverse cumulative
beta distribution. Additionally, it is possible to write the lognormally

S
distributed operational loss O.

O = exp (ξ + τ Y), (7)

IM
Where Y is an additional normal variable and are the lognormal dis-
tribution’s parameters. O and C becomes dependent when an X and Y
connection is specified.

It is still necessary to declare the variables ξ and τ in (7). In the absence

of suitable historical data, the parameters are calculated by solving
M

the equation using a subjective evaluation of the 99.97% quantile op

and the mode m.

m = exp(ξ − τ 2) (8)
N

And

op = exp{ξ + τ Φ−1(p)}, (9)

Where Φ−1(p) is the 99.97% quantile of the standard normal distribu-

tion.

The technique for modelling an operational risk given in this study

must be seen as preliminary due to the scarcity of data on previous
losses. DnB has begun the process of creating a database for oper-
ational losses and creating risk indicators for use in tracking opera-
tional risk (perhaps in coordination with other financial institutions).
As soon as it is determined that the data material is big enough and of
high enough quality, the present model will be improved.

NOTE 9.3.4 MARKET RISK

Market risk is the risk of losses
on financial investments caused A market risk is a result of the financial institution’s open positions
by adverse price movements in the capital, interest rate and foreign exchange markets and it is
 INTEGRATED RISK MODELLING 307

correlated with changes in market prices and exchange rates. The

equities, foreign currency, interest rate and commodities markets all
represent distinct forms of market risk. DnB’s overall market risk is
made up of hazards connected with 15 different instruments and it is
handled by limitations for each category. The financial institution’s
brokerage operations, which primarily include the interest rate and
currency markets, are distinguished by DnB from banking activi-
ties, where investments are made with a longer-term view, such as
in-stock instruments. Out of a total of around 3000 MNOK for the
whole market portfolio, the trading books’ portion barely accounts for
50 MNOK.

Based on the assumption that market liquidity would always be ade-

quate to enable positions to be closed off with a minimum loss, market
risk is commonly quantified using VaR on a short time horizon, such
as 10 days. VaR is beneficial in short-term trading environments but
loses some of its effectiveness when used to assess the market risk

S
brought on by long-term activities. Four arguments are provided by
Hickman for why VaR is inadequate as a long-term measure. One of
the reasons is that the impact of management intervention rules, such
as stop-loss restrictions, which may significantly reduce the cumula-
IM
tive effect of losses in a catastrophic downside scenario, are not well
reflected by VaR.

By setting a holding time for each market item, it considers the like-
lihood that an intermediate loss would be realised in this model to
reduce the risk of big losses. The annual loss is determined by using
M

the worst-case change that happened throughout these holding peri-

ods. The holding durations range from two days for holdings in the
most liquid currencies to 250 days for equity investments (because
the great bulk of the financial institution’s stock investments are long-
N

term).

Let ∆i represent the instrument’s value on day t and I represent the

holding time for instrument i and Pti .
Next, the definition of the change in instrument i on day t is:

Pti − Pti+∆i
Lti = E i ,
Pti
Know More
Where Ei is the instrument’s positional limit. The total of the changes
Market risk is the risk of
in all the instruments, or the change in the whole market portfolio on losses in positions arising from
day t: movements in market variables
like prices and volatility.
LtM = ∑L.
i
i
t

The worst daily change, or market loss over a year, is described as:
M = max LtM .
t
308 FINANCIAL MODELLING

However, it should be noted that any definition of a market loss that is

based on the prices of the instruments is compatible with the method
given below for tying market and credit risk together.

To simulate the daily price variations, Pti go with the traditional

option, the model of geometric Brownian motion.

Pti = Pti −1 exp(dti ),

Where the innovation dti is Gaussian and temporally uncorrelated.

It is a presumption that the innovations at the time t for various instru-

ments are connected. It has computed average daily correlations in its
application. However, this can cause the projected economic capital to
be biassed lower.

Numerous research published recently, have demonstrated that mar-

ket returns are more correlated during times of world unrest. There-

S
fore, one may adopt a model where the correlation changes over time,
as the multivariate GARCH-model proposed by Bollerslev.
IM
As an alternative, one may utilise fixed extreme correlations, which
are the correlations between returns that are very far out in the mul-
tivariate market distribution. Such models may be unstable and chal-
lenging to apply in an operational system.

The average correlations might be substituted in the model with

exceptional correlations discovered by utilising the portions of the
M

1983–2000 period that are characterised by a 5% or greater weekly

decline in the Standard & Poor 500 Index. The correlation between
the Norwegian Stock Market Index (TOTX) and the Standard & Poor
500 Index over these sub-periods was about 50% greater than the
N

overall average correlation. Since the concentration is on unpleasant

occurrences, it is not a concern that constantly use extreme correla-
tions, which causes us to overstate returns in “good times.”
NOTE
The term market risk, also known As shown in (4), the model assumes a link between a market loss M
as systematic risk, refers to the and a credit loss C. This does not mean that it predicts the market
uncertainty associated with any losses from the credit losses. It could equally well have modelled P
investment decision.
(C M) instead of P (M C). The model links a given credit loss to the
observed situation in the market the same year.

There may be a linkage between credit and market losses and the
same macroeconomic causes. It might be challenging to put this strat-
egy into effect. To evaluate how credit and market losses rely on cer-
tain macroeconomic conditions, one must first identify the relevant
macroeconomic parameters. To get around these issues, a straight-
forward strategy is used in which the extent of the credit losses are
allowed to determine the expectation and standard deviation of each
market instrument’s distribution.
 INTEGRATED RISK MODELLING 309

To be more precise, the annual credit loss C is allowed via the pre-
dicted daily geometric return µi and volatility σi of each instrument i
rely on,

µ i = α iC + β i (10)
And

σ i =γ i C +δ i (11)
Figure 9.1 shows the Credit Loss Ratio:
Mean daily geometric return

S
IM
-0.002
-0.004

M
-0.006

0.0 0.01 0.02 0.03 0.04

N

Figure 9.1: Credit Loss Ratio

DnB’s credit loss ratios in the period 1984–1999, plotted against the
mean daily geometric return of FINX in the same years. Regression
lines are superimposed.

Empirically established values are used for the parameters αi, βi, γi
and δi. For selected equities, currencies, interest rates and oil prices
from 1984 to 1991, the annual geometric returns and related standard
deviations, as well as the annual credit loss ratios, were historical data
that was accessible. The credit loss ratios for DnB for the years 1984
to 1999 are displayed in Figure 9.1 against the mean daily geometric
return of FINX for the same years, and they are presented against the
daily geometric return standard deviation for the same years in Fig- NOTE
ure 9.2, respectively. The mean returns and volatilities were used as Market risk is a measure of
response variables and the credit loss ratios as explanatory variables all the factors affecting the
in a linear least squares regression analysis to estimate the parame- performance of financial
ters αi, βi, γi and δi in (10) and (11). markets.
310 FINANCIAL MODELLING

The plots now have the resultant lines placed on them. Figure 9.1
shows that the fit is not particularly strong, but there is a tendency for
substantial credit losses to coincide with FINX’s poor returns. Figure
9.2 shows that although market volatility seems to be low for years
with minor credit losses, it is greater for years with larger credit losses:

0.025
Standard Deviation of daily geometric returns

0.020
0.015
0.010

S
0.0 0.01 0.02 0.03 0.04
IM
Figure 9.2: DnB’s credit loss ratios in the period 1984–1999, plotted
against the standard deviation of the daily geometric returns of
FINX in the same years. Regression lines are superimposed.

SELF ASSESSMENT QUESTIONS

M

3. Which of the following is concerned with the combined

distribution or the distribution of all hazards together, and
has some knowledge of the marginal distribution of each risk
category?
N

a. Product manager
b. Sales manager
c. Deputy manager
d. Risk manager
4. Choosing a common time horizon for all the different risk
categories is another difficulty in ____________.
a. Integrated risk management
b. Financial management
c. Both a. and b.
d. None of these

ACTIVITY

Discuss the limitations of credit risk.

 INTEGRATED RISK MODELLING 311

9.4 IMPLEMENTATION
The main learning from allied disciplines in public services, such as
Change Management, Project Management, Improvement Science,
Quality Improvement, Knowledge Translation and Organisational
Development, is coupled to and built upon during implementation.

Although implementation is still in its early stages, interest in it has

grown over the past ten years. A growing corpus of research has iden-
tified key elements in effective implementation and has documented
instances of employing implementation to assist the provision of ser-
vices, notably in the health, education, social and community contexts.

9.4.1 SIMULATION PROCEDURE

Only via simulation can the intricate distribution of the total loss be
determined. Following the decomposition on the right of the model Know More
(4), sampling from the model produces realisations T1,...., TN of the
total loss (4).

As mentioned in Section 9.3.2 Credit Risk, the credit loss ratios Rj is S Market risk can be defined as
the risk of losses in on and off-
balance sheet positions arising
from adverse movements in
IM
first drawn from the beta distribution to sample the credit losses Cj. market prices.
Using the procedure described in Section 9.3.3 Operational Risk to
simulate operational losses Oj from the distribution P(OjC), and third,
the market losses Mj are drawn dependent on Cj as outlined in Sec-
tion 9.3.4 Market Risk.
M

After sampling each marginal distribution, the total losses Tj = Cj +

Mj + Oj are calculated. An illustration of the DnB group’s total loss
distribution is shown in Figure 9.3:
N
0.0003

95% -quantile 99.97% -quantile

Probability density

4691 MNOK 14585 MNOK

0.0002

99% -quantile
0.0001

7353 MNOK
0.0

0 5000 10000 15000 20000 25000

Total loss (MNOK)

Figure 9.3: The Estimated Total Loss Distribution for the DnB Group
312 FINANCIAL MODELLING

9.4.2 SIMULATION VARIABILITY

Our aim is the economic capital Kp for tiny percentiles p, as stated in

Section 9.3.1 General Risk. Using a Monte Carlo estimate Kp based on
N simulations. An approximate formula for the standard error due to
sampling is:

1 p(1 − p)
se( Kˆ p ) = , (12)
f(K p) N

Where N is the number of runs and f(·) is the probability density func-
tion for Kp. A density estimation approach may be used to estimate
the unknown factor f(Kp) from the simulations. A kernel-density
smoother was used.

One may determine how many simulations are necessary by using (12)
? DID YOU KNOW to assess the Monte Carlo error in the reported estimations of the eco-
Simulation is traditionally used to
reduce errors and their negative
consequences.
nomic capital.
S
The 99.97% quantile for the DnB group (p = 0.9997) is of special sig-
IM
nificance since it relates to the financial institution’s official rating.
Getting a “AA” rating from the top rating agencies is DnB’s stated
objective.

To maintain a “AA” rating, the institution has mandated that risk-ad-

justed capital must cover 99.97% of probable losses over a one-year
M

timeframe.

The coefficient of variation, or se(Kp)/Kp, for various sample sizes for

this quantile as well as the 95% and 99% quantiles are shown in Table
9.1.
N

DnB determined that 500,000 simulations (about one hour on a nor-

mal PC) represented a suitable compromise between accuracy and
computing cost based on the findings in Table 9.1.

Table 9.1 demonstrates that with this many simulations, the upper and
lower 95% confidence bonds (±2se(Kp)) deviate from the expected
99.97% quantile by no more than 2%:

TABLE 9.1: THE COEFFICIENT OF VARIATION ASSOCI-

ATED WITH QUANTILES OF THE TOTAL LOSS DISTRIBU-
TION FOR A DIFFERENT NUMBER OF SIMULATIONS.
Number of Simulations
Quantile
50,000 100,000 200,000 500,000 1,000,000
95.00% 0.005 0.004 0.003 0.0017 0.0001
99.00% 0.009 0.006 0.004 0.0028 0.0020
99.97% 0.029 0.021 0.015 0.0092 0.0065
 INTEGRATED RISK MODELLING 313

SELF ASSESSMENT QUESTIONS

5. Only via simulation can the intricate distribution of the total

loss be determined. Which of the following option is correct
regarding the above statement?
a. Simulation procedure
b. Simulation variability
c. Empirical results
d. None of these
6. One may determine how many simulations are necessary
by using (12) to assess the Monte Carlo error in the reported
estimations of the economic capital. Which of the following
option is correct regarding the above statement?
a. Empirical results
b. Simulation procedure
S
IM
c. Simulation variability
d. Both a and c

ACTIVITY
M

Write a short note on the process of simulation variability.

9.5 EMPIRICAL RESULTS

N

When compared to techniques based on the notion of perfect correla-

tion, the modelling methodology proposed in this study results in sig-
nificant reductions in economic capital. The reductions at the 95% and
99% quantiles are 11% and 12%, respectively, while the drop at the
99.97% quantile is 20% lower than it would have been if the separate
capital needs had been included. This demonstrates that significant
cost savings and improved competitiveness may be realised by mod-
elling the connections across risk classes in a more accurate manner.
Comparing the outcomes of diversification to the actual relationships
between risk classes is intriguing. Table 9.2 displays the associations
in this model. All of the correlations are positive, however, they are all
much lower than 1:

TABLE 9.2: CORRELATIONS BETWEEN DIFFERENT RISK

SOURCES
Credit Market Operational
Credit 1.00 0.30 0.44
S
 INTEGRATED RISK MODELLING 317

c. Credit risk
d. Both a. and b.
5. Which of the following in the portfolio is influenced by how losses
are distributed about one another?
a. Risk level
b. Market level
c. Both a. and b.
d. None of these
6. Which among the following of DnB originates from both direct
and indirect losses brought on by external occurrences like nat-
ural catastrophes and criminal activity?
a. Credit risk
b. Operational risk
c. Market risk
d. Both b. and c.
S
7. The technique for modelling operational risk is seen as prelimi-
IM
nary due to the scarcity of data:
a. Previous profits
b. Current profits
c. Current losses
M

d. Previous losses
8. Which of these is a result of the financial institution’s open posi-
tions in the capital, interest rate and foreign exchange markets?
a. Market risk
N

b. Operational risk
c. Credit risk
d. None of these
9. Which of the following is determined by using the worst-case
change that happened throughout these holding periods?
a. Quarter loss
b. Half-yearly loss
c. Annual loss
d. All of these
10. Which among the following is based on the prices of the
instruments and is compatible with the method given below for
tying market and credit risk together?
a. Credit loss
b. Market loss
318 FINANCIAL MODELLING

c. Both a. and b.
d. None of these

9.8 DESCRIPTIVE QUESTIONS

? 1. Discuss the meaning of risk modelling.
2. Describe the concept of the model.
3. Explain the meaning of operational risk.
4. What do you mean by market risk?

HIGHER ORDER THINKING SKILLS

9.9
(HOTS) QUESTIONS
1. Being in charge of something as huge and complicated as risk
modelling is challenging, yet in just a few weeks, businesses
worth hundreds of billions of dollars have collapsed due to a

S
lack of awareness of key risks and slow response time to possible
losses. Which of the following techniques are used in some of
the world’s biggest financial and economic crises that have been
IM
brought on by corporations’ failure?
a. Capital budgeting techniques
b. Risk modelling techniques
c. Financial techniques
M

d. None of these
2. Which of the following is frequently a problem since it affects
the organisational level; as a result, it must be resolved before
deploying an integrated risk modelling system?
N

a. Data ownership
b. Degree of uncertainty
c. Risk data
d. Business unit-specific risks

9.10 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Meaning of Risk Modelling 1. a. Risk modelling
2. c. Systemic risk
The Model 3. d. Risk manager
4. a. Integrated risk management
Implementation 5. a. Simulation procedure
 INTEGRATED RISK MODELLING 319

Topic Q. No. Answer

6. c. Simulation variability
Empirical results 7. b. Empirical results
8. d. Intriguing

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. d. Systemic risk
2. a. Financial institution
3. b. Credit loss
4. c. Credit risk
5. a. Risk level
6. b. Operational risk
7.
8.
9.
d. Previous losses
a. Market risk
c. Annual loss S
IM
10. b. Market loss

HINTS FOR DESCRIPTIVE QUESTIONS

1. In some areas, including financial services and energy, where
taking measured risk is essential to the business, risk modelling
M

has been used for years. A wide range of risk models and
simulations have lately started to be used by companies in both
the public and commercial sectors to begin tackling strategic,
operational, compliance, geopolitical and other sorts of risk.
Refer to Section 9.2 Meaning of Risk Modelling
N

2. A model is a framework, quantitative method or strategy that

is predicated on hypotheses and uses mathematical, economic,
statistical or financial theories and methods. The model converts
the supplied data into a quantitative estimate. Refer to Section
9.3 The Model
3. The operational risk of DnB originates from both direct and
indirect losses brought on by external occurrences like natural
catastrophes and criminal activity as well as internal causes like
insufficient or inefficient internal procedures and systems. Refer
to Section 9.3 The Model
4. Market risk is a result of the financial institution’s open positions
in the capital, interest rate and foreign exchange markets, and it
is correlated with changes in market prices and exchange rates.
The equities, foreign currency, interest rate and commodities
markets all represent distinct forms of market risk. Refer to
Section 9.3 The Model
 CASE STUDIES
7 TO 9

CONTENTS

Case Study 7 Rajart and Associates — Financial Alternatives

Case Study 8 Building a Recession-Proof Investment Portfolio
Case Study 9 Risk Modelling Techniques

S
IM
M
N
322 FINANCIAL MODELLING

CASE STUDY 7

RAJART AND ASSOCIATES — FINANCIAL ALTERNATIVES

George Thomas was finishing some weekend reports on a Friday

Case Objective afternoon in the downtown office of Wishart and Associates, an
This case study familiarises investment-banking firm. Since Monday, Meenda, a partner with
with different types of the business, had not been in the New York office. He was trav-
securities as per the elling through Pennsylvania, meeting with five potential clients
requirements of different who were exploring securities floatation with Wishart and Asso-
companies.
ciates’ help. Meenda had called George’s secretary on Wednesday
and said he would cable his ideas on Friday afternoon. George
was anticipating the arrival of the cable.

Meenda would be recommending different types of assets to each

of the five clients to fulfil their specific demands, George under-
stood. He also knew Meenda wanted him to phone each of the cli-
ents over the weekend to discuss the recommendations. As soon
as the cable came, George was ready to make these calls. George

S
was prepared to make these calls as soon as the cable arrived. At
4:00 p.m. a secretary handed George the following telegramc

George Thomas, Wishart and Associates STOP Taking advantage

IM
of offer to go skiing in Poconos STOP Recommendations as fol-
lows:
1. Common stock
2. Preferred stock
M

3. Debt with warrants

4. Convertible bonds
5. Callable debentures
N

George understood as he picked up the phone to make the first

call that the potential clients were not matched with the invest-
ment options. George discovered folders on each of the five firms
seeking funding in Meenda’s office. Meenda had scribbled some
handwritten notes on Monday before he departed, and they were
in the front of each folder. George went over each of the notes one
by one.

API, INC

API, Inc. currently requires $8 million and will require $4 million

in four years. In the tri-state area, a packaging company with a
high growth rate. Over-the-counter (OTC) trading is how common
stocks are traded. The stock is currently low, but it is expected to
rise in the next 12 to 18 months. Any sort of security is acceptable
to me. Growth is expected to be mild. Profits should skyrocket
as a result of the new machinery. Debt of $7 million was recently
 CASE STUDY 7: RAJART AND ASSOCIATES — FINANCIAL ALTERNATIVES 323

CASE STUDY 7

paid off. Except for short-term responsibilities, he has essentially

no debt left.

SANDFORD ENTERPRISES

$16 million is required. The stock price has dropped, but it is pre-
dicted to rise. In the following two years, excellent growth and
profitability are expected. Low debt-to-equity ratio, owing to the
company’s history of paying off debt before it matures. The ma-
jority of earnings are retained, while dividends are paid in small
amounts. Management is adamant about not handing over voting
power to outsiders. Money will be utilised to purchase plumbing
materials and machinery.

SHARMA BROTHERS., INC.

S
To expand its cabinet and woodworking operations, it will need
$20 million. Originally a family firm, it now employs 1,200 people,
generates $50 million in revenue, and is traded over the counter.
He is looking for a new shareholder, but he is not willing to stock
IM
at a discount. Straight debt cannot raise more than $12 million.
There are good growth opportunities. Earnings are excellent.
Banks may be prepared to lend money to meet long-term require-
ments.

SACHEETEE ENERGY SYSTEMS

M

The liberal investment community in the Boston area holds the

firm in high regard. The stock is currently trading for $16 per
share. Management would prefer to raise $ 28 million by sell-
ing common shares at $21 or higher, but this is a distant second
N

choice. Those who are likely to invest in this company will be at-
tracted by the financing gimmicks and the opportunity to make a
quick profit on their investment.

RANBAXY INDUSTRY

A total of $25 million is required. The company makes boat canvas

covers and needs money to expand. Money for the long future is
required. Ownership that has been tightly maintained for a long
time is reluctant to relinquish control. Without the authorisation
of bondholders and the First National Bank of Philadelphia, it
is impossible to issue debt. Debt-to-equity ratio is relatively low.
Profits are relatively high. Growth prospects are favourable.
Strong management with slight flaws in the areas of sales and
promotion.
324 FINANCIAL MODELLING

CASE STUDY 7

Meenda’s secretary entered the office as George was going over

the folders. “Did Meenda leave any other stuff here on Monday
other than these notes?” George inquired.

“No, that’s it,” she replied, “but I think those notes will come in
useful.”

Meenda called early this morning to say he had double-checked

the information in the folders. He also stated that he had learnt
nothing new on the trip and that he had essentially squandered
his week, except for the fact that he had been invited to go skiing
at the business lodge up there.

George studied the situation for a while. He could always wait un-
til the next week, when he would be certain that he had the prop-
er advice and that he had taken into account some of the factors
that characterised each client’s demands and position. He could

S
still call the firms by 6:00 p.m. and achieve the initial deadline if
he could figure out which firm fit each recommendation. George
returned to his office and began matching each company with the
proper financing.
IM
QUESTIONS

1. Which type of financing is appropriate to each firm?

(Hint: EBIT-EPS (Approach) Analysis)
M

2. What types of securities must be issued by the firm which

is on the growing stage in order to meet the financial
requirements?
(Hint: Trading on equity)
N
 CASE STUDY 8: BUILDING A RECESSION-PROOF INVESTMENT PORTFOLIO 325

CASE STUDY 8

BUILDING A RECESSION-PROOF INVESTMENT PORTFOLIO

David’s 2009 New Year’s resolve was to create an investment port-

folio that could endure a period of market volatility because ana- Case Objective
lysts were predicting hard times. David, a 45-year-old resident of This case study highlights the
the UK, believed that if he could continuously increase his invest- preparation of a recession-
ment over the following five years, he would be able to accumu- proof investment portfolio.
late a comfortable nest fund before retiring.

David had £10,000 to invest, which was at the moment in a high

street account (high street in the UK refers to “quite common”).
High street quick access accounts are regular savings accounts
with the option for customers to withdraw money anytime they
need to, without incurring any fees. This makes it comparable to
an Indian savings account. Should a recession hit, he wanted to
safeguard his funds. Additionally, he anticipated a conservative
portfolio with minimal danger to savings and modest room for de-

S
velopment over the following five years. Here is how David built
his portfolio with the aid of an Independent Financial Adviser
(IFA).
IM
STOCK MARKET VOLATILITY

Normally, stocks would make up a large portion of a well-diver-

sified investment portfolio. The current unrest, however, pres-
ents some difficult decisions for investors such as David who are
M

attempting to create a portfolio from scratch after five years of

equities market success. Equities no longer appear to be such a
fantastic value.

The FTSE 100 index of leading UK corporations was at a respect-

N

able level of 6,500 at the beginning of 2008. By the end of October,

the index had plummeted by 3,000 points. There is currently no
sign that the present market volatility will soon come to an end.

The index reached 4,300 at the end of 2008. During 2008, equity
markets are anticipated to suffer more. David decided to ensure
that less risky assets made up the majority of his portfolio.

When the markets appear to be fairly inexpensive right now, Da-

vid remarked, “I would be more inclined to take on riskier assets
if I were twenty years younger. It’s probably a terrific moment to
be investing.”

“Sadly, I cannot afford to take any chances at my age. Making

sure my money will be available when I need it is what interests
me the most.”
326 FINANCIAL MODELLING

CASE STUDY 8

INVESTING IN CASH

Cash investments are typically seen as the safest sanctuary during

volatile stock market periods. Cash as an asset class, however, is
starting to appear quite unappealing to savers used to receiving a
rate of interest of 6% or more.

The Bank of England has lowered UK interest rates from 5.25% to

only 1.5% from where they were last year. Because of this, inves-
tors who place their confidence in cash will seldom ever see their
money rise.

Cash investments have a good chance of giving investors no re-

turns at all once inflation and the taxman have taken their respec-
tive percentages.

With £10,000 to invest, David determined that he should put £7,200

S
into a 2008 stocks and shares ISA, putting the entire sum into an
ISA before the 2009 ISA season starts on 6 April 2009.

David would have to wait until after this date to hunt for a Cash
IM
ISA with a higher interest rate, therefore, he would have to retain
£3,000 in his high street immediate access account.

The current cash savings rates are not all that great, but David
noted, “Sometimes peace of mind is more essential than higher
profits.” His money will be protected if his bank fails.
M

INVESTING IN BONDS

David decided to invest in assets that generated a fixed income,

such as corporate and government bonds since he knew that some
N

of his money would have to be held in cash and he wanted the bal-
ance of his portfolio to be able to earn greater consistent returns.

Because they provide investors with a steady stream of payments

(income) and a return on their initial investment at the end of the
investment term, bonds are referred to as fixed-income assets.

Investors can buy shares of a fund that invests in different kinds

of bonds through a bond fund. This has the benefit that the bond
fund is simple to trade and the fund manager may choose the best
investments for you.

DIVERSIFYING BETWEEN DIFFERENT BOND TYPES

David put £5,000 into two different bond funds on the advice of his
IFA. The first investment (£2,000) was made only in government
bonds, the safest kind of investment. David thought that given
 CASE STUDY 8: BUILDING A RECESSION-PROOF INVESTMENT PORTFOLIO 327

CASE STUDY 8

the recent volatility of markets, it made sense to retain a decent

amount of his portfolio as secure as possible.

David also decided to put £3,000 into a different fund that was in-
vested in top-notch corporate bonds that were issued by some of
the greatest businesses in the UK and the world.

In comparison to government bonds, corporate bond markets

now provide a competitive rate of income. The risk associated
with investing in businesses is still far higher than it has ever
been, especially in light of recent high-profile bank failures and
the failure of other businesses.

According to David, “There are instances when you don’t want your
investments to be overly hazardous or difficult. Bonds are safe and
monotonous, which right now is perfect for me.”

INVESTING IN DEFENSIVE EQUITIES

S
David decided to invest part of the remaining £2,200 of his 2008
ISA limit in some larger, more “defensive” UK firms through a
IM
fund in the UK equities income sector. His IFA enquired about
his thoughts on making investments outside of the UK and said
that although there is an increased risk, there is great potential
for development in the international markets.

David decided that he felt more at ease investing in the UK-based

M

funds since he thought the prognosis for the rest of the globe was
so unclear. I enjoy the concept of investing in large UK compa-
nies, the kind of businesses I can keep an eye on in the news and
keep track of their success, he continued.
N

David’s IFA suggested that he complement his bond-focused

strategy with an equity-based one. His equities fund would profit
from the shift in market sentiment if stock prices rose. The IFA
advised David to consider a UK equity income fund, which would
seek to produce a consistent income by investing in protective UK
businesses.

David may always choose to retain the investment’s regular in-

come “rolled up” in the fund and see his money grow that way.

Conclusion Before making any investments, David’s IFA was well

informed of his investing goals and risk tolerance. The IFA be-
lieved that the bulk of the portfolio should be placed in low-risk
assets given David’s age and investing horizon, which was be-
tween five and ten years, even though the stock holding present-
ed some possibility for future gain.
328 FINANCIAL MODELLING

CASE STUDY 8

David clarified: “I’m satisfied with my portfolio and would not

want to have any further investments given how bad the reces-
sion is going this year. Younger investors might not find this type
of portfolio to be sufficiently “racy,” but I have high hopes that it
will fulfil my objectives and provide me with a respectable nest
egg in a few years.”

QUESTIONS

1. Discuss the stock market volatility in this case study.

(Hint: Normally, stocks would make up a large portion of
a well-diversified investment portfolio)
2. Explain the investment in bonds in this case study.
(Hint: David decided to invest in assets that generated a
fixed income, such as corporate and government bonds

S
since he knew that some of his money would have to be
held in cash and he wanted the balance of his portfolio to
be able to earn greater consistent returns)
IM
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 Case Objective
This case study highlights
the financial and economic
crises to use risk modelling
techniques.
332 FINANCIAL MODELLING

CASE STUDY 9

Your chosen IRM system should enable efficient cross-organisa-

tional communication and link you directly to the strategic plan-
ning procedure, corporate goals, business units and various oper-
ations inside these units.

QUESTIONS

1. Discuss the integrated risk modelling in this case study.

(Hint: The term “Integrated Risk Modeling” (IRM) refers
to any risk modelling techniques used by an organisation
to increase risk awareness and decision-making in ways
that enable it to not only survive but also benefit from
risk)
2. Discuss the efficiency of the risk modelling process.
(Hint: To increase the efficiency of the risk modelling

S
process, appropriate software tools and methodologies
should be created and implemented)
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 C H
10 A P T E R

ANALYSING AND CONCLUDING THE MODEL

CONTENTS

10.1 Introduction
10.2
10.2.1
10.2.2
Revolver Modelling

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How does a revolver work in a 3-statement model?
Revolvers are secured by accounts receivable and inventory
IM
Self Assessment Questions
Activity
10.3 Analysing the Output
Self Assessment Questions
Activity
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10.4 Stress Testing the Model

10.4.1 Error Checking
10.4.2 Types of Stress Testing
Self Assessment Questions
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Activity
10.5 Fixing Modelling Errors
10.5.1 The Model Review Process
10.5.2 Seven Types of Errors
Self Assessment Questions
Activity
10.6 Advanced Modelling Techniques
Self Assessment Questions
Activity
10.7 Using the Model to Create a Discounted Cash Flow (DCF) Analysis
10.7.1 DCF Model Basics: Present Value Formula
10.7.2 How to Build a DCF Model: 6 Step Framework
Self Assessment Questions
Activity
10.8 Summary
10.9 Multiple Choice Questions
334 FINANCIAL MODELLING

CONTENTS

10.10 Descriptive Questions

10.11 Higher Order Thinking Skills (HOTS) Questions
10.12 Answers and Hints
10.13 Suggested Readings & References

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 ANALYSING AND CONCLUDING THE MODEL 335

INTRODUCTORY CASELET

MODEL-BASED ANALYSIS

A model-based analysis is a type of analysis that employs model-

ling to carry out the study, record the findings and convey them. Case Objective
Causal loop diagrams and simulation modelling are the two major
modelling techniques employed for social issues. For the first con- This case highlights the
key instrument, i.e., model-
ceptual attacks on the issue, causal loop diagrams are employed. based analysis for tackling
For the remainder of the task, simulation models are used. System challenging social problems.
dynamics has been chosen by [Link] as the best simulation
modelling tool because of its effectiveness, simplicity and focus on
feedback loops.

The model-based analysis is needed to carry out the System

Improvement Process, the method that is currently being imple-
mented. To answer queries like “What are the dominating feed-
back loops that are now creating issue symptoms”, the procedure

S
goes through a sequence of phases and a model is created.

The three main tools diagram explains why the three tools are
required. Difficult social problems like sustainability are so dif-
IM
ficult they require all three tools to solve. That these tools have
not been applied to the sustainability problem as a whole explains
why past solutions have failed. The carpenter has been using the
wrong tools for the job.
M

A Difficult Social Problem

can be solved only by

N

Tool 1
Root Cause Analysis

doing this reliably and efficiently requires

Tool 2
Process Driven Problem Solving

getting this right for this type of problem requires

Tool 3
Model Based Analysis
336 FINANCIAL MODELLING

INTRODUCTORY CASELET

HOW THE WRIGHT BROTHERS USED MODEL-BASED

ANALYSIS

The Wright brothers made history in 1903 when they flew a heavi-
er-than-air powered plane for an extended period under control
with a pilot inside. Many have attempted earlier with no success
since, in contrast to the Wright brothers, they did not apply enough
model-based analysis.

Orville and Wilbur Wright created a set of models to examine

and resolve their numerous subproblems to find a solution to the
problem of how to fly without killing oneself, which was all too
prevalent at the time:
1. In 1899, wing warping as a means of achieving flight control
could be tested using a five-foot-long box kite. The wings
of the kite may be bent by strings linked to it. The model

S
demonstrated how controlled banking to the left or right
might result from wing warping.
2. To further investigate wing warping and lift in 1900, a full-
IM
sized glider was utilised as a kite. To benefit from the robust
winds in the region, this was done in Kitty Hawk. With Wilbur
on board, several flights were performed as a genuine glider.
“The brothers were encouraged because the craft’s front
elevator worked well and they had no accidents.”
3. In 1901, they created a little airfoil and put it in front of a
M

bicycle to test it. The Wright brothers started developing

their data, which was eventually improved in the wind tunnel
when model testing revealed the unreliability of available lift
data.
N

4. After realising that building full-sized glider models required

a lot of money and time, they constructed a six-foot wind
tunnel and started thoroughly evaluating several tiny wing
designs. In their 1902 full-size glider model, the lift, lift-to-
drag ratio and control were all enhanced by the data and
conclusions.
5. They created and tested a brand-new full-sized glider in
1902. There was progress. To increase control, the vertical
rudder was made moveable. There were several model tests
conducted, ranging from 700 to 1000 glides. Roll, pitch and
yaw controls were used to solve all of the lift and steering
concerns. They concluded that they were now prepared to
fly an aeroplane powered by a machine.
6. More wind tunnel testing on propeller models was conducted
at the beginning of 1903. The crucial component of machine-
powered flying, the propeller, was designed using the data.
 ANALYSING AND CONCLUDING THE MODEL 337

INTRODUCTORY CASELET

To prevent torque, two eight-foot propellers were designed,

one for each side, revolving in the opposite direction. All of
their key subproblems had now been resolved using model-
based analysis.
7. Since they could not find any lightweight motors, shop
technician Charlie Taylor created one in under six weeks. The
first Flyer was put together. It barely weighed 605 pounds.
Four successful flights against a 27-mile-per-hour headwind
were performed on December 17, 1903. In 59 seconds, the
last flight covered 852 feet.

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338 FINANCIAL MODELLING

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

> Discuss revolver modelling
> Explain output
> Classify the stress testing of the model
> Describe fixing modelling errors
> Express advanced modelling techniques
> Extent the Discounted Cash Flow (DCF) analysis

10.1 INTRODUCTION
In the previous chapter, you studied integrated risk modelling. An
Quick Revision
organisation’s security, risk tolerance profile and strategic choices are
all influenced by a set of proactive business-wide processes known as

S
Integrated Risk Modeling (IRM). IRM places a greater emphasis on
analysing risks in the broader context of company strategy as opposed
to compliance-based risk modelling methodologies. A collaborative
IM
IRM programme should include executives from the business and IT
sectors.

Financial modelling is a tool used by professionals in many different

industries. Public accountants use it for due diligence and valuations,
bankers use it for sales and trading, stock research and both commer-
M

cial and investment banking and institutions use it for private equity,
portfolio management and research.

Financial modelling inaccuracies can result in costly errors. A finan-

cial model could be provided to an outsider as a result to have the data
N

it includes verified.

To reassure the end-user that the calculations and assumptions con-

tained within the model are accurate and that the results produced by
the model are reliable, banks and other financial institutions, project
promoters, businesses looking for funding, equity houses and others
may ask for model validation.

In this chapter, you will study the revolver modelling, stress testing
the model, fixing modelling errors, advanced modelling techniques,
using the model to create a Discounted Cash Flow (DCF) analysis,
etc., in detail.

10.2 REVOLVER MODELLING

The revolving credit line, or “revolver,” serves as a plug in the majority
of 3-statement models to guarantee that debt is automatically pulled
to cover predicted losses.
 ANALYSING AND CONCLUDING THE MODEL 339

When a surplus is anticipated, cash behaves similarly, to the model

forecasts. NOTE
A revolver refers to a
The model forecasts are discussed below: borrower—either an individual
or a company—who carries a
1. A cash surplus, to calculate the end-of-period cash on the balance balance from month to month,
sheet, the model simply adds the surplus to the preceding year’s via a revolving credit line.
closing cash balance.
2. In a cash deficit, the revolver is used as a plug in the model so
that any cash losses result in further borrowing. This prevents
cash from going negative.

10.2.1 HOW DOES A REVOLVER WORK IN A 3-STATEMENT

MODEL?

How these plugs function in a model will be shown via a short series
of exercises. A straightforward income statement, balance sheet and

10.3.

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cash flow statement are shown in the following figures 10.1, 10.2, and

All three (income statement, balance sheet and cash flow statement)
IM
propositions connect properly.

Example 1: Is the “plug” cash or the revolver, assuming you intend to

have at least `100 in cash throughout the forecast? Why?

Solution: The “plug” in this case is money, as you can see in

Figure 10.1. Since there is a surplus, the model just increases the cash
M

balance after the period by the extra cash earned throughout the time:
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Figure 10.1: Increases the Cash Balance after the period

Example 2: Here, we will increase the expenditure amount on the

income statement from ` 800 to `1,500.
340 FINANCIAL MODELLING

Is the “plug” cash or the revolver, assuming once again that you desire
to have at least ` 100 in cash throughout the forecast as shown in fig-
ure 10.2

S Figure 10.2: Increase the Expenditure

Amount on the Income Statement
IM
Know More Solution 2: The revolver in this instance serves as the “plug.” This
is because the company suffered large losses and without a revolver,
A revolver can sometimes be
referred to as a revolver loan or cash balances would go negative. Here is the solution as shown in fig-
revolving debt. ure 10.3:
M
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Figure 10.3: Negative Cash Balances

Although the core logic in the aforementioned example is quite simple,

the Excel modelling necessary to make the plugs function dynamically
is a bit challenging. Let us take a closer look at the revolver formula
on the balance sheet. How does the revolver balance understand that
 ANALYSING AND CONCLUDING THE MODEL 341

it should increase in a deficit, but decrease in a surplus while never

falling below zero? The following figure 10.4 uses the MIN function to
achieve the following:

S
Figure 10.4: Revolver Formula on the Balance Sheet
IM
10.2.2 REVOLVERS ARE SECURED BY ACCOUNTS
RECEIVABLE AND INVENTORY

Of course, it may be wise to review other assumptions if someone con-

structed a model that shows persistent financial losses that a revolver
M

is now supporting. This is because businesses often utilise a revolver

to cover short-term working capital gaps rather than to cover ongoing
financial losses.

Additionally, there are practical restrictions on how much a business

N

may draw from its revolver. In particular, a “borrowing base” is some-

times used to set a limit on how much money businesses may borrow
from the revolver. The quantity of liquid assets backing the revolver
often accounts receivable and inventories are represented by the bor-
rowing base. The usual calculation is 80% of the “liquidation value” of
the inventory plus 90% of the accounts receivable.

SELF ASSESSMENT QUESTIONS

1. Which of the following serves as a plug in the majority of

3-statement models to guarantee that debt is automatically
pulled to cover predicted losses?
a. Revolver
b. Analysing the output
c. Stress testing the model
d. None of these
NOTE
Stress Testing is a software
testing technique that
determines the robustness of
software by testing beyond the
limits of normal operation.
344 FINANCIAL MODELLING

methods to assess how well the assets they manage may withstand
certain market developments and outside catastrophes.

Stress testing a financial model is the crucial final stage in prepara-

tion. A valuable talent for raising the caliber of a financial model is
the capacity to stress test one and identify any problems in it. Stress
testing makes sure there won’t be any mistakes once the model has
been given to the last user.

Despite the fact that stress testing a financial model helps to avoid
unhappy customers, managers and executives, this last step is fre-
quently skipped.

Testing the logic of the formulas used into the financial model’s com-
putations is one of the simplest ways to conduct a stress test. If the
results make sense, it may be determined by doing a quick sanity
check. Filling the formula down or to the right into neighboring cells
and checking to see if the change properly propagates through is a

S
more robust version of this test. Are the values produced by the filled-
down formula appropriate? If not, there could be a formula reference
that was missed and has to be corrected. One of the statement’s lines
is incorrectly referenced, as may be seen in the figure below. These
IM
faults are found via stress testing are showing in Figure 10.5:
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Figure 10.5: Stress testing a financial model

It is prudent to stress test the formulas relating to the assumptions

because a financial model uses assumptions to calculate projected val-
ues. Check the formula with all likely and conceivable values for the
assumptions. Check to see if the formulas still work when the assump-
tion is decreased, increased, flipped, or set to zero. A closer examina-
tion of the formula logic may be necessary for that particular assump-
tion if, in any event, the formula malfunctions or becomes absurd.
NOTE
Stress testing is defined as the
process of testing the hardware
or software for its stability under
a heavy load condition.
 ANALYSING AND CONCLUDING THE MODEL 347

Figure 10.6 shows rationalising a model review system:

You
Professional Model
Auditor
Know More
Modeling error in linear or
nonlinear control systems is
the main issue that should be
addressed in designing model-
2 16 150+ based filtering approaches to
Hours spent reviewing achieve high-accuracy state
estimation.

Figure 10.6: Rationalising a Model Review System

Observation 1: You have limited time

evaluating financial models.

S
Professional model auditors must set up a LARGE amount of time for

In actuality, spending 150+ hours examining a model is not uncom-

IM
mon. This is the end of the scale for stakes.

Let us pretend you have a lot less time—say, between two and sixteen
hours. Given that, we will need to adopt a new strategy to maximise
the use of our time.

Observation 2: All models contain errors, but they matter to varying

M

degrees.

As hinted at in the post’s beginning, the objective is to be less incorrect

rather than entirely correct.
N

Remember that no amount of review, no matter how thorough, can

guarantee perfection. Single-person code examination only finds 20%
to 40% of all problems, according to Panko [2016].

Note that this rises (to 63%) when inspectors use a technique for the
review, according to different research by the same author (Panko
[1999]).

Your time is limited, so we can make good use of the Pareto distribu-
tion. For our purposes, we can crudely paraphrase this: 20% of the
faults account for 80% of the anticipated output errors.

A quick disclaimer: This is a mind-set, not a policy. I’m not advocat-

ing a 20% tolerance, but rather how to strategically identify the main
sources of mistakes.

This is NOT a “leave no stone unturned” strategy.

348 FINANCIAL MODELLING

Observation 3: The model is a hierarchy shown in Figure 10.7:

Top down view

IRR, NPV

Cash flow |P&L| B/S

OPS CON DEBT EQ D&T

Bottom up view Timing

S Figure 10.7: Hierarchy Model

(Source: [Link]
cles/2021/intro-to-financial-modelling-part-14)
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Where:

OPS = Operations

CON = Construction/expansion

DEBT = Debt
M

EQ = Equity

D&T = Depreciation & Taxation

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Every financial model has a goal—or a set of goals—in mind. Examples

include determining the worth of an asset, aiding in decision-making
by analysing potential outcomes and how they could affect important
variables and providing variance analysis between historical data and
the budget. The majority of these essential outputs are found in the
financial statements or at the valuation level (for example, IRR and
NPV) (cash flow, P&L and balance sheet).

The financial statements and the valuation metrics are a hierarchy

that is built up from all of the model’s separate modules. Therefore,
concentrate first on the balance sheet, P&L and cash flow during your
examination and feel free to be intrusive.

Conclusion: Triage your review with a process, not a checklist.

In summary,
1. Due to schedule constraints
2. Aim to make fewer errors by employing
 ANALYSING AND CONCLUDING THE MODEL 349

3. A method that benefits from the model hierarchy. Sound too

basic? It is far better than utilising an extensive checklist or a
random method.

Although useful, exhaustive checklists are likely to be disregarded.

Nobody has time to analyse a financial model independently or accord-
ing to the 103 things you should accomplish.

10.5.1 THE MODEL REVIEW PROCESS

If you accept the aforementioned assumption, then we should learn

more about the process and discuss the main categories of faults that
the process should highlight as shown in Figure 10.8:

• Understand commercials, model flow and turn model to simple

Top down view

• Row differences (Maps, or Ctrl+\)

items

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• Transition points and Charts (Alt + F1) on Cash flow Items & B/S

• Warnings & Alerts in model (B/S doesn’t balance, CF < 0)

IM
2. Systematic Extreme Value, Founding & Directional
• Connect Cash flow Waterfall//Statement, bring in Scenario Manager
• Create a CF Data table
• Plug in extreme values for major drivers of NPV & record changes.
• Set debt = 100%, equity = 100%, explore known inverse relationship
M

3. Other Checks: Not As Quick Wins

• Trace Dependents around input fields
• Check background items: Name Manager, Macros, Hidden sheets
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4. Cell By Cell: The Grind

• Similar to Commercial Review but more detailed
• Use Maps, Transition points, Check, Anchoring, Charts
Bottom up view • Use F9/ software tool (e.g. BPM Traverse) to check formula links.

Figure 10.8: Model Review Process

(Source: [Link]
cles/2021/intro-to-financial-modelling-part-14)

Putting the following technique after analysing financial models from

a variety of angles, including self-review, assessing others’ models
(for things like credit procedures) and acting as a professional model
auditor. This is also the result of several discussions with other model
reviewers, as well as from training and procedure improvement.

Many phases in the picture will be reasonably self-explanatory, but we

will quickly describe each step before adding depth to this framework
 `
`
 Know More
Advanced modeling lets the
application designer manually
add objects to an application
design.

NOTE
Advanced Modelling Techniques
in Structural Design introduces
numerical analysis methods
to both students and design
practitioners.

NOTE
The discounted cash flow (DCF)
formula is equal to the sum of
the cash flow in each period
divided by one plus the discount
rate (WACC) raised to the power
of the period number.
354 FINANCIAL MODELLING

them to determine the company’s present value. Both in academics

and practice, DCFs are often utilised. For investment bankers, pri-
vate equity professionals, equity researchers and “buy side” investors,
valuing businesses using a DCF model is seen as a key competency.

A DCF model calculates an organisation’s intrinsic value (the value

based on an organisation’s capacity to produce cash flows) and is often
used to compare an organisation’s intrinsic worth to its market value.

Apple, for instance, has a market value of almost ` 909 billion. Based
on the company’s fundamentals and anticipated future performance
(i.e., its intrinsic worth), is that market price justified? A DCF specif-
ically aims to respond to such a question. DCF Analysis for Apple is
shown in Figure 10.10:

S
IM
Figure 10.10: DCF Analysis for Apple
M

The rationale behind the DCF model is that the value of a firm is not
a function of arbitrary supply and demand for that company’s shares,
in contrast to market-based valuation methods like a similar company
analysis. Instead, a company’s worth depends on its potential to pro-
N

vide future cash flow for its owners.

10.7.1 DCF MODEL BASICS: PRESENT VALUE FORMULA

To calculate a company’s current value using the DCF technique, we

NOTE must anticipate its future cash flows and discount them to the present.
Investors can use the concept Investors should be prepared to pay this present value (the company’s
of the present value of money worth). The following formula may be used to explain this (with r to
to determine whether the future represent the discount rate):
cash flows of an investment
or project are greater than the
Cash flow
value of the initial investment. Preset value t=0 =
(1 +γ )t=1

Suppose you decide to spend `800 on the items shown in Figure 10.10.
This may be resolved using the calculation as follows:

1,000
800 =
(1 + 25%)1
 `
`

t n
Cash flowt
t rt

Know More
Present value (PV) is the
current value of a future sum of
money or stream of cash flows
given a specified rate of return.
 `
`
 `

` `
` `
S
360 FINANCIAL MODELLING

2. Which among the following is sometimes used to set a limit on

how much money businesses may borrow from the revolver?
a. Accounts receivable
b. Borrowing base
c. Accounts payable
d. None of these
3. Which of these is a typical tool used by businesses that manage
assets and investments to assess portfolio risk?
a. Borrowing base
b. Analysing the tool
c. Cash surplus
d. Stress testing
4. A simulation based on a past crisis is conducted for the firm,

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asset class, portfolio or individual investment.
Choose the correct option regarding the above statement.
a. Hypothetical stress testing
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b. Simulated stress testing
c. Historical stress testing
d. None of these
5. The financial statements and the valuation metrics are a
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hierarchy that is built up from which of these?

a. Schedule constraints
b. Random method
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c. Stress testing
d. Model’s separate modules
6. Which of the following are the types of errors?
a. Anchoring
b. Tools
c. Model infrastructure
d. All of these
7. After taking into account all operational costs and investments,
step one is to anticipate the cash flows a business produces from
its main activities.
Which among the following option is correct regarding the above
statement?
a. Calculating the terminal value
b. Discounting the cash flows to the present at the weighted
average cost of capital
 ANALYSING AND CONCLUDING THE MODEL 361

c. Forecasting unlevered free cash flows

d. Subtract debt and other non-equity claims
8. The DCF’s main objective is to seize the equity owners’ property
(equity value). Which option is correct regarding the above
statement?
a. Add the value of non-operating assets to the present value of
unlevered free cash flows
b. Divide the equity value by the shares outstanding
c. Subtract debt and other non-equity claims
d. Calculating the terminal value

10.10 DESCRIPTIVE QUESTIONS

?
1. Discuss the concept of revolver modelling.
2. What do you mean by stress testing the model?
3. Explain the Advanced modelling techniques.
4. Describe the DCF Model. S
IM
HIGHER ORDER THINKING SKILLS
10.11
(HOTS) QUESTIONS
1. You must estimate a lump-sum valuation of the firm beyond the
explicit forecast period to make certain high-level assumptions
M

regarding cash flows beyond the last explicit forecast year. Which
of the following option is correct regarding the above statement?
a. Calculating the terminal value
b. Discounting the cash flows to the present at the weighted
N

average cost of capital

c. Divide the equity value by the shares outstanding
d. Add the value of non-operating assets to the present value of
unlevered free cash flows
2. We must include any non-operating assets, such as cash or
investments, which a firm may have on its balance sheet when
calculating the current value of unlevered free cash flows. Which
of the following option is correct regarding the above statement?
a. Calculating the terminal value
b. Discounting the cash flows to the present at the weighted
average cost of capital
c. Divide the equity value by the shares outstanding
d. Add the value of non-operating assets to the present value of
unlevered free cash flows
362 FINANCIAL MODELLING

10.12 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Revolver modelling 1. a. Revolver

2. b. Cash surplus

Analysing the output 3. a. Financial analysis

4. b. Internal analyst

Stress testing the model 5. a. Hypothetical stress

testing

6. b. Simulated stress testing

S
Fixing modelling errors

Advanced modelling techniques

7.

8.

9.
b.

d.

a.
Model infrastructure

Both a. and b.

Conditional rules
IM
Using the model to create a 10. c. Discounted cash flow
Discounted Cash Flow (DCF) model
Analysis

11. d. Investors
M

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
N

1. c. Cash deficit

2. b. Borrowing base

3. d. Stress testing

4. c. Historical stress testing

5. d. Model’s separate modules

6. d. All of these

7. c. Forecasting unlevered free cash flows

8. c. Subtract debt and other non-equity claims

HINTS FOR DESCRIPTIVE QUESTIONS

1. The revolving credit line, or “revolver,” serves as a plug in
the majority of 3-statement models to guarantee that debt is
automatically pulled to cover predicted losses. When a surplus is
 C H
11 A P T E R

VARIANCE-COVARIANCE MATRIX

CONTENTS

11.1 Introduction
11.2
11.2.1
11.2.2 S
Sample Variance-Covariance Matrix
Fixed-Weight Historical
Exponential Smoothing
IM
11.2.3 Multivariate GARCH
Self Assessment Questions
Activity
11.3 The Correlation Matrix
Self Assessment Questions
M

Activity
11.4 Computing the Global Minimum Variance Portfolio (GMVP)
Self Assessment Questions
Activity
N

11.5 Alternatives to the Sample Variance-Covariance

11.5.1 The Single-Index Model (SIM)
11.5.2 Constant Correlation
11.5.3 Shrinkage Methods
Self Assessment Questions
Activity
11.6 Using Option Information to Compute the Variance Matrix
Self Assessment Questions
Activity
11.7 Summary
11.8 Multiple Choice Questions
11.9 Descriptive Questions
11.10 Higher Order Thinking Skills (HOTS) Questions
11.11 Answers and Hints
11.12 Suggested Readings & References
366 FINANCIAL MODELLING

INTRODUCTORY CASELET

THE GENETIC VARIANCE-COVARIANCE MATRIX

Although phenotypic correlations between traits can occasion-

Case Objective ally result from environmental factors, it also happens that traits
under some shared genetic controls do not correlate in the phe-
This caselet highlights the notype as a result of opposing environmental factors. Traits that
phenotypic correlations
between traits. share genetic factors are expected to show phenotypic covariance
between trait values. The additive genetic covariance between
characteristics is; therefore, estimated by scientists researching
the development of traits.

Covariance between features that may be handed down to the

next generation is described by additive genetic covariance,
which is similar to additive genetic variance. There are several
methods for estimating additive genetic covariance, which need
some understanding of how people are linked; Lynch and Walsh

S
provide a full explanation of these methods. The P matrix and G
matrix are terms used by biologists to refer to the variance-cova-
riance matrices for phenotypic data.
IM
Researchers also assessed the genetic variance-covariance matrix
for emergency time, maximum height and tiller number in each
population of reed canary grass in the study detailed in the Exer-
cise below. Because they raised collections of plants that were
genetic clones of one another, the researchers were able to deter-
mine the G matrix. The population of plants in France has a G
M

matrix of 0000149.57.6907.6910.27.

There was no genetic covariance with the other two qualities since
there was no genetic variation for emergence time. The genetic
covariance between maximal height and tiller number, however,
N

is somewhat negative. This number implies that plants are geneti-

cally restricted to generate fewer tillers while they grow taller, and
the opposite is also true.
 VARIANCE-COVARIANCE MATRIX 367

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

> Discuss the sample variance-covariance matrix
> Explain the correlation matrix
> Classify the computing of the Global Minimum Variance
Portfolio (GMVP)
> Describe the alternatives to the sample variance-covariance
> Express the Single-Index Model (SIM)
> Extent the using option information to compute the variance
matrix

11.1 INTRODUCTION
In the previous chapter, you studied the analysis of the model. Finan-

S
cial modelling is a tool used by professionals in many different indus-
tries. In addition to being used by institutions for private equity, port-
folio management and research are also used by public accountants
Quick Revision
IM
for due diligence and valuations, bankers for sales and trading, stock
research and both commercial and investment banking.

A square matrix called a variance-covariance matrix holds the vari-

ances and covariances related to various variables. The variances of
the variables are contained in the matrix’s diagonal elements, while
M

the covariances of every conceivable pair of variables are contained in

the off-diagonal members.

As an illustration, imagine that you make a variance-covariance

matrix for the three variables X, Y and Z. The variances of X, Y and Z
N

are 2.0, 3.4, and 0.82 correspondingly in Table 11.1:

TABLE 11.1: VARIANCES OF X, Y AND Z

Know More
X Y Z
A covariance matrix is a square
X 2.0 -0.86 -0.15 matrix giving the covariance
Y -0.86 3.4 0.48 between each pair of elements
of a given random vector.
Z -0.15 0.48 0.82

This table shown in bold along the diagonal. There is a -0.86 covari-
ance between X and Y.

Because the covariance between X and Y is equal to the covariance

between Y and X, the variance-covariance matrix is symmetric. To
display the covariance for each pair of variables twice in the matrix,
the ith and jth variables’ covariance is presented at places I j) and (j, i).

A covariance matrix, which is a square matrix, shows the variance

displayed by dataset elements as well as the covariance between two
368 FINANCIAL MODELLING

datasets. Variance, a metric of dispersion, can be characterised as the

spread of data from the dataset’s mean. The calculation of covariance
between two variables is used to assess how the two variables fluctu-
ate collectively.

The definition of a variance-covariance matrix is a square matrix in

which the off-diagonal members stand in for the covariance and the
diagonal elements for the variance. Positive, negative or zero covari-
ance between two variables is all possible. Positive covariance denotes
a positive link between the two variables, whilst negative covariance
denotes a negative association. Two items will show 0% covariance if
they do not fluctuate together.

In this chapter, you will study the variance-covariance matrix, sam-

ple variance-covariance matrix, the correlation matrix, computing
the Global Minimum Variance Portfolio (GMVP), alternatives to the
sample variance-covariance, using option information to compute the
variance matrix, etc., in detail.

11.2
MATRIX
S
SAMPLE VARIANCE-COVARIANCE
IM
The historical covariance technique will likely be a poor estimator
NOTE of the actual variance-covariance matrix, according to the apparent
Covariance matrix is a type of instability of the unconditional covariance matrix. As a result, for pre-
matrix that is used to represent dicting risk exposures, more complicated models of the evolution of
the covariance values between
the variance-covariance matrix may be needed.
M

pairs of elements given in a

random vector.
The equally weighted historical method, exponentially weighted mov-
ing average approach and GARCH approach are the three kinds of
models. Other additional models might be employed. However, we
have limited ourselves to the models (and straightforward modifica-
N

tions of those models) now employed by Australian banks.

The stability analysis in the preceding section was based on com-

mon covariance and correlation metrics that account for the sample
mean of each series throughout each sub-period. The stability analy-
sis assumes that the mean of each series of financial returns is zero.
When calculating market risk exposures, this presumption is a widely
accepted market practice. The variance-covariance matrix estima-
tions may be worsened by the inclusion of an erroneous estimate of
the mean since the mean is theoretically near zero and subject to
estimation error. The addition of the estimated means will not signifi-
cantly alter the results if the conventional method for variances and
covariances is used since the squared return component is 100–1,000
times larger than the mean component.

While some banks update the variance-covariance matrix every day

as part of their VaR model implementation, it is standard practice at
other institutions to only do so once every three months. As a conse-
quence, two sets of projections are taken into account: the forecasts
 VARIANCE-COVARIANCE MATRIX 369

for one day in the future and the anticipated average variances and
covariances for the upcoming quarter.

11.2.1 FIXED-WEIGHT HISTORICAL

The fixed-weight method is based on the supposition that the vari-

ances and covariances of returns are constant across the sample
period. This is an incorrect assumption, as shown by the variance-co-
variance matrix’s instability as observed. On account of its simplicity,
it is commonly employed. This method may be used to express each
component of the variance-covariance matrix as:

1 N −1
σ 2 ij, t + 1 = ∑
N S =0
ri, t − s rj, t − s

where ri,t−s represents the market return for asset i between days
t−s−1 and t−s.

11.2.2 EXPONENTIAL SMOOTHING

S
IM
Exponential smoothing gives greater weight to the most recent data
than it does to earlier ones. JP Morgan made use of this strategy in Know More
their Risk Metrics VaR model to gain popularity (JP Morgan and
Covariance Matrix is a measure
Reuters, 1996). The exponentially weighted moving average method of how much two random
responds more quickly to transient variance and covariance changes. variables change together. It is
This quicker response is advantageous if the underlying variances actually used for computing the
M

and covariances are not consistent over time. On the other side, a covariance in between every
column of data matrix.
smaller sample size results from putting more weight on recent data,
which raises the likelihood of measurement error. In the variance-co-
variance matrix, each element is represented by:
N

σ2ij, t+1= λσ2 ij, t+(1– λ)ri, j rj,t

where 0<λ<1

An exponentially weighted average is made up of two parts on any

given day: the weighted average from the previous day, which weighs,
and the product of returns from the previous day, which weighs (1−λ).
This equation reflects the idea of volatility clustering by using an
autoregressive structure for the variance-covariance. Two strategies
are used in the analysis that comes next. The first is to assume that
is λ fixed at 0.94 by the Risk Metrics definition. The second strategy
involves applying maximum likelihood approaches to estimate λ over
a series of rolling windows (this approach can be referred to as the
dynamic exponentially weighted moving average approach).

The model is developed using maximum likelihood techniques over

the entire dataset to evaluate the accuracy of fixing λ at 0.94 (λ was
restricted to take the same value for all matrix members). This inves-
tigation yielded a value of 0.995 using the foreign exchange covariance
matrix.
370 FINANCIAL MODELLING

Like the equally weighted method the k-step ahead one-day forecasts
are constant and the quarter-average forecast is equal to σ2ij, t+1. To see
this:

Et(σ2ij, t+k) = Et((1– λ)rij, t+k–1 rj, t+k–1+ λσ2ij, t+k–1)

= (1– λ)σ2ij, t+k–1 + λσ2ij, t+k–1

= σ2ij, t+k–1

11.2.3 MULTIVARIATE GARCH

The ARCH model proposed by Engle is generalised in Bollerslev’s

? DID YOU KNOW (1986) work as the GARCH model (1982). The specification of vari-
MGARCH stands for multivariate ances and covariances refers to stochastic processes that change over
GARCH, or multivariate time. Given that volatility clustering can be explicitly simulated, the
generalised autoregressive theory behind these models is conceptually comparable to that of the
conditional heteroskedasticity. exponentially weighted method. However, there are fewer limitations

S
on how the behaviour of the volatilities may be specified. The GARCH
model is stacked inside the first two models. The model collapses to the
fixed-weight historical model if and α and β in the specification below
IM
are both zero. The model is comparable to the exponentially weighted
model if is equal to zero, α = (1−λ) and β = λ. The zero-mean GARCH
(1,1) model has the following form in a univariate setting:
Rt = rt
rt /It-1~ N(0, Ht)
M

Ht = ω+ αr2t-1 + βHt-1

It is assumed that the vector of innovations or unexpected returns

has a conditional variance of Ht and is conditionally normal. Although
the specification of the development of the covariances can get more
N

involved, the multivariate framework is identical to the univariate in

that the variance-covariance matrix is dependent on historical reali-
sations of covariances of financial returns.

The more basic multivariate models use the assumption that vari-
ances and covariances are dependent on both their past values and
innovations as well as the past values and innovations of other vari-
ables. These generic models have so many parameters that need to
be estimated that as the number of variables rises, computing may
become impossible.

For instance, one of the more generic models requires 243 parameters
to be evaluated for our nine-by-nine foreign exchange matrix. There
is a need for a more frugal parameterisation because the focus is on
a model’s forecasting ability, which necessitates frequent rolling esti-
mates of the models.

Two models are applied to this goal. The first model is the Bollerslev’s
constant correlation multivariate GARCH model (1990).
 VARIANCE-COVARIANCE MATRIX 371

The model’s benefit is that it reduces the number of parameters that

must be estimated to 3p + p(p1)/2, where p is the total number of
financial returns. Variances are calculated using the straightforward
GARCH (1,1) formula:
σ2ij, t+1 = ωi+ αir2i, t + βiσ2i, t
The covariances are formulated as:
σij, t+1 = ρij σi, t+1 σj, t+1

The variance parameters must be subject to non-negativity require-

ments to guarantee that the conditional variance estimates are always
positive. Since the system is recursive, stationarity demands that αi +
βi < 1 for all i.

The model’s parameters are calculated using maximum likelihood

methods. The maximum likelihood estimator is asymptotically nor- Know More
mal when there is standard regularity. Using the Bernt, Hall, Hall and MGARCH allows the
Hausman (1974) method, the log-likelihood is maximised. The itera-
tion method takes a very long time because of the log-very likelihood’s
non-linear nature. Rolling estimate is computationally infeasible even
after the constant correlation assumption is applied to the model due S conditional-on-past-history
covariance matrix of the
dependent variables to follow a
flexible dynamic structure.
IM
to the total of 63 parameters in the whole system (for the nine-by-nine
foreign exchange variance-covariance matrix). The strategy used is
to estimate independent bivariate systems for each pair of financial
returns to allow rolling estimation. Seven parameters for each of these
36 systems need to be calculated.
M

The whole variance-covariance matrix may be created from these

bivariate systems. Estimates derived by pair-wise estimation may be
inaccurate and skewed to the degree that covariances are in reality
jointly determined. The covariance matrix’s positive definiteness can-
N

not be guaranteed by this method, but it does make forecasting pos-

sible and tractable. This approach provides only one estimate of each
covariance, but ρ−1 estimate for the ω, α and β parameters for each
variance. The average of the ρ−1 forecasts of each variance is used.

The constant correlation GARCH model’s one-day-ahead GARCH

variance forecast is provided by:

σ 2 i, t + 1 = ω + α i r2 i,t + β iσ 2 i,t
ωi r
= + α i ∑ β i j r 2 i, t − j
1 − βi j =0

T represents the length of data used in the estimation. It follows that

the k-step ahead forecast has the form:

ωi
σ 2 i,t + k / t = ωi + (α i + β i )k−1 (σ 2 i,t +1 − ωi ) where ωi =
1 − α i − βi
372 FINANCIAL MODELLING

and hence, are not constant in k. Given these variances in forecast

functions the average one-day forecast over a quarter (containing N
days) is:

1 2  1 − (α i + β i ) N 
σ Ai
2
= ωi + (σ i, t +1 − ωi )   if α i + β i ≠ 1
N  1 − α i − βi 

Given the constant correlation assumption, the covariance predic-

tions are straightforward functions of these variance forecasts and the
parameters pij.

The Babba, Engle, Kraft and Kroner (BEKK) parameterisation is the

second multivariate GARCH model that is employed for forecasting.
This model was developed by Engle and Kroner (1995), whose qua-
dratic form ensures that the conditional covariance matrix would be
positive definite. The model has the form:

NOTE
S
Ht+1 = C'C +B'HtB + A'RtR'tA

The parameter matrices that must be estimated are A, B and C. A vec-

IM
tor of returns for time t is called Rt. The calculated variance-covari-
GARCH is a statistical model ance matrix at time t is called Ht. Once more, using the unconstrained
that can be used to analyse a
number of different types of
BEKK model would need too much computing time for this forecast-
financial data, for instance, ing experiment.
macroeconomic data. Financial
institutions typically use this The parameter matrices are given a diagonal shape to improve tracta-
M

model to estimate the volatility bility and eliminate cross-market impacts. The required non-negativ-
of returns for stocks, bonds and
market indices.
ity requirements are automatically imposed by the model. The entire
model is estimated as opposed to generating estimates pair by pair.

The GARCH parameters are substituted with squared parameters in

N

the BEKK model, which results in variance forecasts that have the
same structure as those from the GARCH constant correlation model.

The constant correlation assumption is relaxed for the covariance

predictions in the BEKK model, which have the same specification as
the constant correlation GARCH variance equations.

SELF ASSESSMENT QUESTIONS

1. Which of the following called a variance-covariance matrix

holds the variances and covariances related to various
variables?
a. Square matrix
b. Diagonal matrix
c. Both a. and b.
d. None of these
 VARIANCE-COVARIANCE MATRIX 373

2. Which of the following gives greater weight to the most recent

data than it does to earlier ones?
a. Multivariate GARCH
b. Fixed-weight historical
c. Exponential smoothing
d. Both a. and b.

ACTIVITY

Find out the advantages of the covariance matrix.

11.3 THE CORRELATION MATRIX

coefficients for various variables.

S
Simply said, a correlation matrix is a table that shows the correlation

The matrix depicts the correlation between all the possible pairs of
IM
values in a table. It is an effective tool for compiling a sizable data-
set and for locating and displaying data patterns. The variables are
shown in rows and columns of a correlation matrix. The correlation
coefficient is contained in each cell of a table.
M

The correlation matrix is commonly used with other kinds of statis-

tical analysis as well. It could be useful, for instance, when analysing Know More
numerous linear regression models. A correlation matrix is
“square”, with the same
Keep in mind that the models include several independent variables. variables shown in the rows
N

In a model for multivariate linear regression, the correlation matrix and columns.
determines the correlation coefficients between the independent vari-
ables.

HOW TO CREATE A CORRELATION MATRIX IN EXCEL?

Let us look at the next example to better understand the processes

required to create a correlation matrix in Excel. You work as an
investment bank stock analyst. Recently, your boss instructed you to
examine the price correlations of the equities that may be added to the
portfolio. The equities of the following corporations are then exam-
ined: NVIDIA, Ford, Shell and Alphabet.

Making a correlation matrix is the most effective technique to exam-

ine the relationships between the stock prices of the firms stated
above. To do it, download the information into Excel and sort it into
the appropriate columns.
374 FINANCIAL MODELLING

The stock prices of several companies are shown in each column for
the given period (from December 2015 to November 2018) as shown in
Figure 11.1:

S
IM
Figure 11.1: Correlation Matrix in Excel
M

The following are the procedure to create the correlation matrix in

excel:
1. Select the Data Analysis button under the Analse group in the
NOTE
N

Data tab.
Most correlation matrixes use
Pearson’s Product-Moment The Data Analysis dialog box appears.
Correlation (r). It is also common
2. Select the Correlation option in the Data Analysis dialog box.
to use Spearman’s Correlation
and Kendall’s Tau-b. Both 3. Click the OK button.
of these are non-parametric
correlations and less susceptible The Correlation dialog box appears.
to outliers than r.
4. Type in the input range including the company names and stock
values.
5. Select the Columns radio button for the Grouped By: option
(because our data is arranged in the columns).
6. Select the Labels in First Row checkbox (the first rows of each
column contain the names of the companies).
7. Select the preferred output choice (i.e., the location on the
spreadsheet where the correlation matrix will appear).
8. Press the OK button.
 VARIANCE-COVARIANCE MATRIX 375

Your matrix should look like as shown in Figure 11.2:

Figure 11.2: Matrix

SELF ASSESSMENT QUESTIONS

3. The correlation matrix establishes the correlation coefficients

between the independent variables in a model for
a. Multivariate linear regression
b. Exponential smoothing
c. Fixed-weight historical
d. None of these
S
IM
ACTIVITY

Discuss some limitations of the correlation matrix.

COMPUTING THE GLOBAL MINIMUM

11.4
M

VARIANCE PORTFOLIO (GMVP)

The Global Minimum Variance Portfolio (GMVP) and efficient port-
folios are the two most common applications of the variance-covari-
N

ance matrix. Consider a scenario where N assets each have an S vari-

ance-covariance matrix. The GMVP is the portfolio with the lowest
variance out of all viable portfolios, x = {x 1, x 2, …, x N}. The mini- Know More
mum variance portfolio is defined by: The global minimum variance
portfolio (GMVP) allocates a
1row ⋅ S −1 given budget among n financial
XGMVP = {xGMVP,1 , xGMVP,2 ,..., xGMVP, N } = assets such that the variance
1row ⋅ S −1 ⋅ 1Trow
of the portfolio return is
1row ⋅ S −1 minimised.
where 1row = {1, 1,..., 1} =
 Sum ( numerator)
↑
N-dimensional
row vector of 1s

 xGMVP, 1  1
  1
 xGMVP, 2  S −1 1column  
xGMVP =  = T −1
, where 1column =  
   1column ⋅ S ⋅ 1column  
x  1
 GMVP, N  
↑
N −dimensional
column vector of 1s
376 FINANCIAL MODELLING

S −1 1column
=
Sum( numerator)

This formula is due to Merton.

The particular fascination of the minimum variance portfolio is that it

is the only portfolio on the efficient frontier whose computation does
not require the asset’s expected returns. The mean μGMVP and the vari-
NOTE ance σ2GMVP of the minimum variance portfolio are given by:
The global minimum variance
portfolio lies to the far left of the μGMVP = xGMVP .E(r), σ2GMVP = xGMVP .S. x2GMVP
efficient frontier and is made up
of a portfolio of risky assets that
produces the minimum risk for EXHIBIT
an investor.
Excel’s MMULT function to solve for Portfolio Variance

Only if the portfolio has 2 or 3 stocks it is possible to use a formula

S
to determine portfolio variance. When a portfolio has more than
three stocks, utilising that method to solve the problem becomes
difficult and time-consuming. This makes utilising Excel’s MMULT
IM
function to account for portfolio variance perfect. Two matrices
can be multiplied using this function. Having stated that, one must
comprehend the fundamentals of matrices before discussing the
MMULT function. From a matrix perspective, portfolio variance is
expressed as:
M

Wt × (Covariance Matrix) × W

In the above equation, W refers to the column vector of stock weights.

It is the third matrix that consists of a single column. Meanwhile,
N

Wt refers to the transpose of stock weights (row vector). It is the

first matrix that consists of a single row. Finally, covariance matrix
refers to all the possible pairs of covariances. Keep in mind that the
order mentioned in the above equation is important - first matrix
is the row vector of stock weights, second matrix is the covariance
matrix, and third matrix is the column vector of stock weights.

So, σ p2 = W t *×Covariance
CovarianceMatrix
Matrix* ×
WW

 Cov1,1 Cov1,2 Cov1,3 … Cov1, n   W1 

 Cov Cov2,2 Cov2,3 … Cov2, n   W2 
 2,1  
= [W1 W2 W3 *  Cov3,1 Cov3,2
… Wn]× Cov3,3 … Cov3, n ×*  W3 
   
         
Covn Covn Covn,3 … Covn, n  Wn 
 ,1 ,2
378 FINANCIAL MODELLING

Let us do that below figure 11.4:

Figure 11.4: Calculation of Covariance using MMULT Function

Before we explain the above image, here is an important thing to

keep in mind.

S
If you are using the latest version of Microsoft Office 365, you can
directly hit enter after inputting all the required arrays in the
MMULT function to generate the output.
IM
However, if you are using any other version of Microsoft Office, you
may need to press Shift + Control + Enter to generate the output.

Now, in the above image, notice the highlighted cell E6 and the for-
mula that was used to calculate this, in cell F6. As you can see, there
is an error (#VALUE!). The reason why there is an error is because
M

the number of columns in the weight matrix (1) did not match with
the number of rows in the covariance matrix (2).

Hence, there is a need to transpose the weights, so that the matrix

changes from a 2x1 to a 1x2 matrix. So, the calculation of covari-
N

ance shown in figure 11.5:

Figure 11.5: Calculation of Covariance using

MMULT Transpose Function

The result of the product of the two matrices has been calculated
in cell E6 and the formula that was used to calculate this has been
written in cell G6.

Notice that multiplying a [1×2] matrix with a [2×2] matrix results

in a [1×2] matrix, as can be seen in the highlighted cells E6 and F6.
 VARIANCE-COVARIANCE MATRIX 379

Now, this resulting product must be multiplied by the third matrix

(which is the column vector of stock weights) to get the value of the
portfolio variance, as shown in figure 11.6:

Figure 11.6: Calculation of Portfolio Variance

using MMULT Function

In the above image, notice the highlighted cell E8 and the formula
that was used to calculate this in cell F8. See that the resulting
product (E6#), which is a [1×2] matrix (E6:E7), is multiplied by the
column vector of stock weights, which is a [2×1] matrix.

S
Notice that multiplying a [1×2] matrix with a [2×1] matrix results
in a [1×1] matrix, as can be seen in the highlighted cell E8. This
value, 0.010536, is nothing but the portfolio variance.
IM
Instead of using the function MMULT twice, one can further
shorten the work by nesting an MMULT within another MMULT.
To understand how to do this, as shown in figure 11.7:
M

Figure 11.7: Calculation of Portfolio Variance using Twice MMULT

Transpose Function
N

In the above image, notice the highlighted cell E6 and the formula
that was used to calculate this in cell F6. Notice how MMULT has
been nested inside another MMULT, to directly generate the port-
folio variance.

SELF ASSESSMENT QUESTIONS

4. Which of the following are the two most common applications

of the variance-covariance matrix?
a. Global Minimum Variance Portfolio (GMVP) and efficient
portfolios
b. Global Minimum Variance Portfolio (GMVP) and risk port-
folios
c. Efficient portfolios and risk portfolios
d. All of these
NOTE
The single-index model (SIM) is
a simple asset pricing model to
measure both the risk and the
return of a stock.
 VARIANCE-COVARIANCE MATRIX 381

numcols = [Link]
Dim matrix() As Double
ReDim matrix(numcols - 1, numcols - 1)
For i = 1 To numcols
For j = 1 To numcols
If i = j Then
matrix(i - 1, j - 1) = Application. _
WorksheetFunction.Var_S([Link](i))
Else
matrix(i - 1, j - 1) = _
[Link](assetdata. _
Columns(i), marketdata) * _
[Link](assetdata. _
Columns(j), marketdata) * _
[Link].Var_S(marketdata)
End If
Next j
Next i
sim = matrix
End Function

S
The asset returns and market returns make up this function’s two
parameters.
IM
Using this code in the illustration as shown in Figure 11.8:
M
N

Figure 11.8: Computation of the Single-Index

Variance-Covariance Matrix

EXHIBIT

Visual Basic for Applications (VBA) Function

The legacy program Visual Basic from Microsoft Corporation (NAS-

DAQ: MSFT) includes Visual Basic for Applications (VBA). VBA is
a programming language that may be used to create applications
for the Windows operating system and is supported by Microsoft
Office (MS Office, Office) programs including Access, Excel, Pow-
erPoint, Publisher, Word and Visio.
382 FINANCIAL MODELLING

Beyond what is typically possible with MS Office host apps, VBA

enables users to modify.

VBA is an event-driven tool, so you can use it to instruct the com-

puter to start doing a single operation or a series of related tasks.
You create bespoke macros—a.k.a. macroinstructions—by entering
commands into an editing module to do this.

A macro is simply a string of letters that, when entered, produces a

different string of characters as its output, carrying out a certain set
of computational operations.

Because VBA is the version of Visual Basic that comes with Micro-
soft Office, you don’t need to buy the VBA program.

VBA is not an independent application. Instead, it gives users the

ability to interact with GUI elements including toolbars, menus,
conversation boxes and forms. User-defined functions (UDFs),

S
Windows application programming interfaces (APIs), and the auto-
mation of particular computer operations and computations are all
possible with VBA.
IM
VBA in Excel

Each software in the Office suite may incorporate VBA code to

improve the product. All of the Office suite programs use a common
programming language.
M

VBA has worked better with Excel than other Office suite tools
because of the repetitive nature of spreadsheets, data analytics and
data organisation.

The usage of macros is frequently the foundation of the connection

N

between VBA and Excel.

VBA is used in Excel to execute macros, while it can also be used

for non-macro tasks.

11.5.2 CONSTANT CORRELATION

By assuming that the variances of the asset returns are sample returns
and that all covariances are related by the same correlation coeffi-
cient, typically taken to be the average correlation coefficient of the
assets in question, the constant correlation model of Elton and Gruber
Know More (1973) computes the variance-covariance matrix.
The constant correlation model
is a mean-variance portfolio Since Cov(ri,rj) = σij = ρijσiσj, this means that in the constant correla-
selection model where, for a tion model:
given set of risky securities, the
correlation of returns between  σ ij = σ i2 when i = j
any pair of different securities σ ij = 
is considered to be the same. σ ij = ρσ iσ j when i ≠ j
 VARIANCE-COVARIANCE MATRIX 383

The data for the 10 stocks can be used to put the constant correlation
model into practice.

One can begin by calculating the correlations between each stock as

shown in Figure 11.9:

Figure 11.9: Estimating the Constant Correlation Variance-Covari-

ance Matrix

S
Below is a VBA function to compute this matrix from the return data:

Function constantcorr(data As Range, corr As Double) _

As Variant
IM
Dim i As Integer
Dim j As Integer
Dim numcols As Integer
numcols = [Link]
numrows = [Link]
Dim matrix() As Double
M

ReDim matrix(numcols - 1, numcols - 1)

If Abs(corr) > = 1 Then GoTo Out
For i = 1 To numcols
For j = 1 To numcols
If i = j Then
N

matrix(i - 1, j - 1) = Application. _
WorksheetFunction.Var_S([Link](i))
Else
matrix(i - 1, j - 1) = corr * jjunk(data, i) * _
jjunk(data, j)
End If
Next j
Next i

Out:

If Abs(corr) > = 1 Then constantcorr = VarCovar(data) _

Else constantcorr = matrix
End Function

11.5.3 SHRINKAGE METHODS

Recently, a third category of techniques for calculating the vari-

ance-covariance matrix has grown in favour.
384 FINANCIAL MODELLING

The variance-covariance matrix is a convex combination of the sam-

ple covariance matrix and another matrix, according to so-called
shrinkage methods.

Shrinkage variance-covariance matrix = λ×Sample var-cov + (1+ λ)×

Other matrix

In the example, as follows, the “other” matrix is a diagonal matrix of

only variances, with zeros elsewhere.

The shrinkage estimator λ = 0.3 (cell B20) as shown in Figure 11.10:

S
IM
M
N

Figure 11.10: Estimating the Variance-Covariance Matrix Using the

Shrinkage Approach

There is little theory about choosing the proper shrinkage estimator.

Our suggestion is to choose a shrinkage operator λ so that the GMVP

is wholly positive

SELF ASSESSMENT QUESTIONS

5. The variance-covariance matrix is a convex combination of

the sample covariance matrix and another matrix, according
to so-called
a. Shrinkage methods b. Correlation methods
c. Both a. and b. d. None of these
 VARIANCE-COVARIANCE MATRIX 385

ACTIVITY

Find out some advantages of the Single-Index Model (SIM).

USING OPTION INFORMATION TO

11.6
COMPUTE THE VARIANCE MATRIX
Utilising data from the options market is another method for comput-
ing the variance matrix.

One can calculate the variance matrix using constant correlation and
the implied volatility for each of the equities from them at-the-money
call options:
 σ2i, implied if i = j
σ ij = 
ρσ i, implied σ j, implied if i ≠ j

S
Here’s an example of our 10-stock case as shown in Figure 11.11:
IM
M
N

Figure 11.11: Comparing Implied and Historical Volatility

386 FINANCIAL MODELLING

One can now use the implied volatilities as the basis for a constant
correlation variance-covariance matrix as shown in Figure 11.12:

S
IM
Figure 11.12: Constant Correlation Matrix with Implied Volatilities

The programming of the ImpliedVolVarCov is similar to previous

VBAs in this chapter:
M

Function ImpliedVolVarCov(varcovarmatrix As _
Range, volatilities As Range, corr As Double)
As Variant
Dim i As Integer
Dim j As Integer
N

Dim numcols As Integer

numcols = [Link]
numrows = numcols
Dim matrix() As Double
ReDim matrix(numcols - 1, numcols - 1)
If Abs(corr) > = 1 Then GoTo Out
For i = 1 To numcols
For j = 1 To numcols
If i = j Then
matrix(i - 1, j - 1) = volatilities(i) ∧ 2
Else
matrix(i - 1, j - 1) = corr * _
volatilities(i) * volatilities(j)
End If
Next j
Next i
Out:
If Abs(corr) > = 1 Then ImpliedVolVarCov = _
"ERR" Else ImpliedVolVarCov = matrix
End Function
S
 VARIANCE-COVARIANCE MATRIX 389

c. Covariance matrix
d. None of these
3. Which of the following will likely be a poor estimator of the
actual variance-covariance matrix, according to the apparent
instability of the unconditional covariance matrix?
a. Square matrix technique
b. Diagonal matrix technique
c. Historical covariance technique
d. Both a and c
4. The stability analysis assumes that the mean of each series of
financial returns is
a. Infinite
b. Finite
c. Zero
d. Both a. and b. S
IM
5. Which of the following is based on the supposition that the
variances and covariances of returns are constant across the
sample period?
a. Fixed-weight historical
M

b. Exponential smoothing
c. Multivariate GARCH
d. All of these
N

6. The ARCH model proposed by Engle is generalised in Bollerslev’s

(1986) work as the GARCH model (1982). Which of the following
option is correct regarding the above statement?
a. Exponential smoothing
b. Multivariate GARCH
c. Fixed-weight historical
d. Both a. and b.
7. Which of the following is a table that shows the correlation
coefficients for various variables?
a. Diagonal matrix
b. Square matrix
c. Covariance matrix
d. Correlation matrix
390 FINANCIAL MODELLING

8. Which of the following was developed to reduce the number of

complicated computations required to calculate the variance-
covariance matrix?
a. Exponential smoothing
b. Fixed-weight historical
c. Single-Index Model (SIM)
d. None of these

11.9 DESCRIPTIVE QUESTIONS

?
1. Discuss the square matrix.
2. Explain the sample variance-covariance matrix.
3. Describe the correlation matrix.
4. Interpret sample variance-covariance.

11.10 S
HIGHER ORDER THINKING SKILLS
(HOTS) QUESTIONS
IM
1. Which of the following claims about an endogenous variable is
true in the context of simultaneous equations modelling?
a. Endogenous variables’ values are decided outside of the sys-
tem
b. The system can have fewer equations than endogenous vari-
M

ables.
c. No endogenous variables will appear on the right-hand side
of reduced form equations.
d. Only endogenous variables will be present on the RHS of re-
N

duced form equations.

2. The covariance is:
a. A measure of the strength of the relationship between two
variables.
b. Dependent on the units of measurement of the variables.
c. An unstandardised version of the correlation coefficient.
d. All of these

11.11 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

Topic Q. No. Answer

Sample Variance-Covariance 1. a. Square matrix
Matrix
 VARIANCE-COVARIANCE MATRIX 391

Topic Q. No. Answer

2. c. Exponential smoothing
The Correlation Matrix 3. a. Multivariate linear
regression
Computing the Global Minimum 4. a. Global Minimum Vari-
Variance Portfolio (GMVP) ance Portfolio (GMVP)
and efficient portfolios
Alternatives to the Sample Vari- 5. a. Shrinkage methods
ance-Covariance
Using Option Information to Com- 6. a. Options market
pute the Variance Matrix

ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. b. Symmetric
2.
3.
c. Covariance matrix
c. Historical covariance technique
S
IM
4. c. Zero
5. a. Fixed-weight historical
6. b. Multivariate GARCH
7. d. Correlation matrix
8. c. Single-Index Model (SIM)
M

HINTS FOR DESCRIPTIVE QUESTIONS

1. A square matrix called a variance-covariance matrix holds the
variances and covariances related to various variables. The
N

variances of the variables are contained in the matrix’s diagonal

elements, while the covariances of every conceivable pair of
variables are contained in the off-diagonal members. Refer to
Section 11.1 Introduction
2. The historical covariance technique will likely be a poor
estimator of the actual variance-covariance matrix, according to
the apparent instability of the unconditional covariance matrix.
As a result, for predicting risk exposures, more complicated
models of the evolution of the variance-covariance matrix may
be needed. Refer to Section 11.2 Sample Variance-Covariance
Matrix
3. The correlation between all potential pairings of values in a
table is shown in the matrix. It is an effective tool for compiling
a sizable dataset and for locating and displaying data patterns.
The variables are shown in rows and columns of a correlation
matrix. The correlation coefficient is contained in each cell of a
table. Refer to Section 11.3 The Correlation Matrix
 C H
12 A P T E R

RECRUITING, INTERVIEWING AND SELECTION

CONTENTS

12.1 Introduction
12.2

S
Recruiting and Interviewing
Self Assessment Questions
Activity
IM
12.3 Financial Institutions and Investment Banks
Self Assessment Questions
Activity
12.4 Process of Interviewing
12.4.1 General Interviewing Overview
M

12.4.2 Qualitative/fit Questions

12.4.3 Technical Questions
12.4.4 Post Interview
12.4.5 Following up
N

12.4.6 Selecting a Firm

12.4.7 Selecting a Group
Self Assessment Questions
Activity
12.5 Investment Banking
Self Assessment Questions
Activity
12.6 Selection
12.6.1 How to Hire Financial Advisors?
Self Assessment Questions
Activity
12.7 Summary
12.8 Multiple Choice Questions
12.9 Descriptive Questions
12.10 Higher Order Thinking Skills (HOTS) Questions
12.11 Answers and Hints
12.12 Suggested Readings & References
394 FINANCIAL MODELLING

INTRODUCTORY CASELET

SINGER INDUSTRIES LIMITED

Suresh Kumar was production manager for Singer Industries

Case Objective Limited, a Noida based electrical appliances company near Delhi.
This caselet highlights Singer Suresh had to approve the hiring of new supervisors in the plant.
Industries Limited, a close-by The HR manager performed the initial screening.
manufacturer of electrical
goods. Anil Dhavan, Singer’s HR Director, called Suresh on Friday in the
late afternoon. He said “Suresh, I just spoke with a recent engi-
neering graduate from a local engineering college who would be
the perfect fit for the supervisor position you asked me about.
Despite earning a lower pay, he has some decent job experience
with a global company in Pune. He wants to travel to Noida to visit
his folks.” “Well, Anilji, I will take care of the boy,” Suresh replied.
“He is currently at my office, and if you are free, I will send him
to you”, said Anil. Before responding, Suresh was silent for a time

S
“Great Sir, I am undoubtedly busy today, but I also can’t afford to
offend you. Sir, immediately send him, please.”

The new candidate, Ranga Rao, entered Suresh’s office shortly

IM
after and introduced himself. Suresh urged Rao to enter his cabin
and said “I have a few critical phone calls to make, but I will be
right there with you.” Suresh ended the calls after fifteen min-
utes and started interrogating Rao. Suresh was astonished as the
candidate’s ability was demonstrated by the merit certificates, the
best idea prize from a prior international company and his swift
M

reactions. Meanwhile, a supervisor shouted, “We have a tiny prob-

lem on line number 5 and need your aid,” and opened Suresh’s
door.

Suresh returned fifteen minutes later and the conversation pro-

N

ceeded for a few minutes before a series of phone calls once again
stopped him. Suresh said, “Excuse me for a minute, Rao.”

For the following forty minutes, there were further interruptions

in the same pattern. Inconveniently, Rao glanced at the watch and
said, “Sorry, Suresh, but I have to leave right away. The train to
Pune leaves at nine o’clock.”

As the phone rang once again, Suresh answered, “Sure, Rao.”

“Call me in a week”.
 RECRUITING, INTERVIEWING AND SELECTION 395

LEARNING OBJECTIVES

After studying this chapter, you will be able to:

> Discuss recruiting and interviewing
> Explain the financial institutions and investment banks
> Classify the process of interviewing
> Describe the general interviewing overview
> Analyse the selection process
> Interpret the concept of selecting a firm

12.1 INTRODUCTION
In the previous chapter, you studied the variance-covariance matrix. Quick Revision
A square matrix called a variance-covariance matrix holds the vari-

S
ances and covariances related to various variables. The variances of
the variables are contained in the matrix’s diagonal elements, while
the covariances of every conceivable pair of variables are contained in
IM
the off-diagonal members.

The creation and upkeep of suitable workforce sources is recruitment.

It entails building a pool of readily accessible human resources that
the organisation may use to draw from when it needs more workers.
Recruitment is the process of luring candidates to open positions in
M

an organisation who possess particular qualifications, aptitudes and

personality traits.

Denerley and Plumblay (1969) assert that recruiting involves both

enlisting the necessary quantity of individuals and assessing their
N

calibre. In addition to addressing immediate demands, it also has an

impact on how a firm will develop in the future. The requirement for
recruiting may result from:
i. Openings caused by promotions, transfers, terminations,
retirement, permanent disabilities or death;
ii. Openings caused by business expansion, diversification, growth
and other factors.

People chosen for the organisation based on criteria other than merit
would not fit in well and cause several issues for both the company NOTE
and the other employees. The process begins with recruitment and Recruiting is the stage of the
moves through selection and placement before coming to an end. employee life cycle in which
Manpower planning is the initial stage in the procurement function, prospective candidates are
sourced, interviewed and
and recruitment comes after that. The organisation can recruit the assessed in order to identify the
individuals it needs in the numbers and demographics it needs. Find- best fit for a job opening.
ing possible candidates for current or future organisational openings
entails recruiting.
396 FINANCIAL MODELLING

“Recruitment is a procedure to uncover the sources of personnel to sat-

NOTE isfy the requirements of the staffing schedule and to utilise efficacious
The recruitment process means for attracting that workforce in enough numbers to permit suc-
involves finding the candidate cessful selection of an efficient working force,” note Yoder and others.
with the best skills, experience
and personality to fit the job.
As a result, the goal of recruiting is to identify sources of labour that
can fulfil the needs and criteria of a given position.

In this chapter, you will study recruiting and interviewing, financial

institutions and investment banks, the process of interviewing, selec-
tion, etc., in detail.

12.2 RECRUITING AND INTERVIEWING

Although people management has been practised for about 70 years,
its significance has just lately undergone a significant shift. There
are now several levels of bureaucracy due to the complexity and size
expansion of the majority of organisations. All businesses and organ-

S
isations are aware of the rising cost of labour. A strategic human
resources management concept has recently been created by schol-
ars. This viewpoint essentially adopts a wider and more comprehen-
sive perspective of the people’s function. It looks to connect the peo-
IM
ple function to an organisation’s long-term goals and asks how it may
make those goals and strategies easier to achieve. Organisations are
rethinking old beliefs about career planning to provide workers with
more alternative career choices and also take into account their life-
style demands while moving them from one station to another due to
increased concern with careers and life fulfilment. This tendency is
M

fairly prevalent in the hotel sector.

The most valuable resource in every organisation is its human capi-

tal. The quality of the employees of an organisation determines much
N

of its success or failure. Organisations cannot advance and thrive

without the positive and innovative contributions of individuals. An
organisation has to hire people with the relevant knowledge, training
and experience to accomplish its objectives. They must accomplish
this while keeping in mind both the organisation’s current and future
needs. Employment and selection are not the same as recruitment.
Before choosing qualified applicants for employment, management
must first identify where the needed human resources will be acces-
sible and how to attract them to the organisation. Once the required
quantity and kind of human resources are known.

Interviewing is the most common resource or instrument utilised in

social casework; hence interviewing skills are the fundamental abilities
on which the success of all other process elements depends. The idea
and nature of interviews and the most common instrument employed
in social casework should already be familiar to you. Additionally, you
have acknowledged that communication is a key component of the
interviewing process. In other words, you should be able to under-
stand the “what,” “why,” “when” and “where” of a social casework
 RECRUITING, INTERVIEWING AND SELECTION 397

interview. You must now become familiar with the social casework
interview’s “how.” Although aspiring professionals might be able to Know More
understand the notion of an interview, doing so in practical and real- As interviewing is the most
world settings can be quite challenging. They experience uneasiness used resource or tool of social
case work, interviewing skills
and a lack of confidence before beginning or continuing an interview.
are the central skills on which
They could also struggle to maintain the momentum. They are inter- all the components of the social
ested in learning “how to start an interview, what questions to ask or case work process depend.
not ask and how to deal with emotionally sensitive situations.” They
do accept that assisting individuals in need while also doing it effec-
tively is a key component of social casework, a basic way of the social
work profession.

SELF ASSESSMENT QUESTIONS

1. The most valuable resource in every organisation is its:

a. Human capital
b. Human resource management
c. Strategic management
d. None of these S
IM
ACTIVITY

Find some key terms for recruiting with the help of the Internet.
M

FINANCIAL INSTITUTIONS AND

12.3
INVESTMENT BANKS
In the financial institutions, financial activities are a crucial compo-
N

nent of any economy, and consumers and businesses rely on financial NOTE
institutions for transactions and investments. As a result, financial A corporation that deals
institutions provide services to the majority of people. The govern- with financial and monetary
ment considers the supervision and regulation of banks and other activities such deposits, loans,
financial institutions important due to their crucial role in the econ- investments, and currency
exchange is known as a
omy. Financial institution failures have led to panic in the past. financial institution (FI).
Regular bank accounts are insured in the United States by the Federal
Deposit Insurance Corporation (FDIC) to reassure people and com-
panies about the security of their money with financial institutions.
The strength of a country’s financial sector is essential to its overall
economic stability. A bank run is a simple outcome of losing trust in a
financial organisation.

Financial institutions are crucial because they offer a market for

money and assets, enabling effective capital allocation to the most
beneficial uses. As an illustration, a bank accepts client deposits and
loans the money to borrowers. Without the bank acting as a middle-
man, it would be difficult for one person to discover a suitable bor-
 Know More
The major categories of
financial institutions are central
banks, retail and commercial
banks, internet banks, credit
unions, savings and loan
associations, investment banks
and companies, brokerage
firms, insurance companies and
mortgage companies.
NOTE
An investment bank is a financial
services company that acts as
an intermediary in large and
complex financial transactions.
 Know More
The interview process typically
includes the following steps:
writing a job description,
posting a job, scheduling
interviews, conducting
preliminary interviews,
conducting in-person
interviews, following up with
candidates and making a hire.
402 FINANCIAL MODELLING

The key to a good interview is preparation, which also increases your

self-confidence in your interviewing abilities.

12.4.2 QUALITATIVE/FIT QUESTIONS

Researchers that use qualitative methods aim to comprehend phe-

nomena that statistics alone cannot fully capture. Qualitative research,
although frequently referred to be a soft scientific technique, aids in a
complex understanding of people.

The best interview candidates should be devoted to comprehending

NOTE relevant power dynamics before approaching places of interest while
The interview process is a multi- speaking with qualitative researchers. Candidates without empathy
stage process for hiring new
employees. or reflexivity should be avoided.

The following are the researcher qualitative interview questions:

1. How would you select appropriate projects?

S
You can select relevant projects by demonstrating an
understanding of one’s interests, social requirements and
knowledge gaps.
IM
2. What distinguishes participants from collaborators in the most
important ways?
Collaborators join in to assist participants.
3. What would you do if a subject showed signs of reluctance to
participate in your study?
M

Examines the ability to protect participants’ volition.

4. How would you respond to those who question the value of
qualitative research?
N

Demonstrates self-assurance in these endeavours and the

capacity to have civil debates regarding research.
5. When would you discuss your findings with the participants?
Evaluates how well participants’ feedback has been respected
throughout the project.

12.4.3 TECHNICAL QUESTIONS

Candidates are evaluated through technical interviews for careers in

IT, engineering and science. They contain inquiries that are pertinent
to the position for which you have applied, enabling the employer to
determine if you possess the necessary qualifications. They frequently
consist of logical exams, number reasoning issues or brain teaser chal-
lenges.

Although it is crucial, interviewers are also concerned about how

applicants tackle challenges, organise their mental processes and
exhibit interpersonal skills like communication.
 Know More
Behavioral questions allow you
to find the best fit for each role,
and help you hire employees
who can drive innovation,
productivity, customer
satisfaction and profits.
NOTE
The interview process is an
important phase in recruitment.
It helps an employer understand
whether a candidate is ideal
for a job and aids the candidate
in determining whether the job
suits them or not.
406 FINANCIAL MODELLING

Every company and the employer are unique. The recruiter and you
may communicate during the interview process. Alternatively, you
might speak with the recruiting manager directly.

Regardless, it’s crucial to decide who you want to get in touch with
personally. Ensure that you have accurately spelt their name. Then,
say thank you and appreciate it. Although the recruiting process may
appear straightforward, it is not. A candidate may need to pass through
several approval processes and hoops, depending on the business.

It is time to restate your interest after thanking the person for their
time. Mention the position and the employer, along with your excite-
ment for the chance. Make sure to include the date of the interview
and the precise position title. If a recruiter is responding to your mes-
sage, they probably have several vacant positions and prospects on
their plate.

Finally, be direct. Inquire about the status of the job for which you have

S
been interviewed. Ask about the subsequent stages. At this point, you
could also provide other details like references. Finally, add one more
expression of thanks to the end of your email.
IM
But wait a moment before sending. Have you had this edited for mis-
takes? Have you used spellcheck or another grammar checker on the
email? What is the gist of your voice? Are you still having a good atti-
tude? Or what changes can you make if you sound frustrated?
M

WAYS TO FOLLOW UP AFTER A JOB INTERVIEW

There are specifics to post-interview follow-up. Every organisation

has a unique approach to the interview process. So, you could encoun-
ter many situations when you look for a job.
N

THE INITIAL THANK YOU INTERVIEW

Sending a thank-you email within 24 to 48 hours of seeing the inter-

viewer is often a good idea.

Each organisation is unique. Some businesses might do just one inter-

view. Others, like BetterUp, could do many rounds of interviews.

Regardless, you ought to send a thank-you note after every meeting

with a new interviewer. Say Maria recently spoke with a recruiter on
the phone about a marketing position. The next step would be for her
to meet the team because she is interested in the position.

She discovered during the phone interview that her skills exactly fit
the position. She also gained additional knowledge about the corpo-
rate culture and career prospects. After her phone interview, Maria
chooses to write a thank you follow-up email since she is anxious to
learn what comes next.
 RECRUITING, INTERVIEWING AND SELECTION 407

YOU’RE WAITING TO HEAR IF YOU’VE MADE IT TO THE NEXT

ROUND

This response most likely will not suit your tastes. However, you need
to be patient as you wait to find out if you have advanced to the next
round of interviews. It may be irritating in this situation.

But it will take time if there are several contenders in the running.

Consider your personal experience first. There may have been tele-
phonic interviews or emails regarding recruitment. Recall how many NOTE
individuals you may have already spoken to during interviews. An interview process is
a multistep practice that
Now increase it by the number of candidates for the position. Addi- companies use to screen
tionally, double it on the recruiter’s end by any available positions candidates from a larger
pool. It allows managers and
they might be hiring for.
company stakeholders to gauge
if candidates are a good fit for
Say David has just finished his first interview with the hiring manager their company.
and the recruiter. He was first informed by the recruiter that there

S
would be three rounds of interviews. With the VP of the team comes
the third and final round. David just finished his interview with the
recruiting manager two days ago.
IM
After the interview, he already wrote a thank-you message, so he
chooses to be patient while waiting to hear about the next round. He
speaks with his coach, who advises him to hold off on following up for
at least a week.

It’s OK to send a follow-up message if you have not heard back from
M

them after 7–10 days. You may even request feedback from the inter-
view. But make an effort to be patient.

YOU’RE WAITING FOR THE FINAL DECISION AFTER A JOB

N

INTERVIEW

Theoretically, it should not take long for businesses to decide on this.

If you have gone through all the interview stages, you are aware that
they like you. They are intrigued, but they have probably only selected
a small number of final applicants.

With the final round of applicants, the schedule will probably be the
deciding factor. Let us imagine that the final round has been reached
by three contestants, including you. You may be the first applicant to
have successfully passed the last round of interviews. Behind you, two
additional applicants could be conducting interviews.

It should not take long for the business to choose after all of the can-
didates have finished the last round of interviews. It is OK to inquire
about the number of candidates participating in the last round of
interviews from the recruiter. You can get a better idea of the time-
frame by doing that.
408 FINANCIAL MODELLING

Assume Arianna has finished the three interviews for the post of a
software engineer. She breezed through the first and second rounds
with ease. However, setting up the third round with the team’s director
required more time. Before her third and final interview, she enquired
as to the number of applicants. Arianna discovered that there was only
room for one contestant.

Her last interview, which was also a working interview, was just a day
ago. Arianna chooses to wait it out in the hopes of receiving a response
soon. Unsurprisingly, Arianna gets a call from the recruiter on day
four with a job offer.

Send a follow-up email if you have not heard anything after 7 to 10

days. After the interviews are over, perhaps you will hear relatively
quickly; that is always a positive indication! Keep your head up if you
have not received anything back from your follow-up email yet. There
are several options available. You will discover the best person to

12.4.6
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assist you in realising your greatest potential.

SELECTING A FIRM
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You want to work for a company that offers a positive work atmo-
sphere, partners who are available to answer any concerns you have,
mentors throughout the company, an increased salary to help pay off
that hefty school loan and the opportunity to advance reasonably rap-
idly.
M

Keep in mind that the field you have selected has expectations that,
when you sit and think about them, could appear intimidating. A sig-
nificant element is often a rise in total remuneration. The long-term
potential, however, is more important than the initial starting remu-
N

neration. If you get the invitation, you should at the very least under-
stand the lockstep associate ranges and, more importantly, the part-
nership chances.

BALANCING WORK AND LIFE IS ALWAYS CHALLENGING

Regardless of the business, you select. It appears that the moment

you decide to establish a family is also the time when business in
the legal profession is briskest. You have made a challenging career
choice. Years, when you establish and raise a family, are directly and
significantly at odds with years when you learn your trade, hone your
speciality, get acceptance, get promoted and forge relationships with
clients. What you can do is talk about the decisions you will make with
your life partner to handle the process as efficiently as possible. U.S.
News & World Report also offered some advice on how to deal with
workplace stress.
 RECRUITING, INTERVIEWING AND SELECTION 409

DO NOT ASSUME THAT SIZE ALWAYS MATTERS

Do not expect that working for a smaller legal firm entails a few hours
and workplace kumbaya. Many lawyers who transition from large firms
to smaller ones are horrified to discover that the hours and demands
remain the same. They are further troubled to discover that what they
mistakenly believed to be a millennial workplace with group hugs and
unlimited kombucha on tap is a place where the need to produce is of
utmost importance. To that purpose, in-house positions can demand
longer hours and lower pay than those at legal firms. This knowledge
is not easily accessible through online sources or self-praise. A skilled
recruiter will be aware of the variations in expectations between dis-
tinct career paths.

CHOOSE A FIRM BASED ON THE PEOPLE

Choose a company depending on the staff. Although the structural

elements are useful, it is ultimately up to the decision makers to deter-

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mine where you belong inside the system. When you are asked to join
the partnership, it does not matter if a company has $4 million in PPP.
If you are a person who stands out and is appropriately acknowledged,
IM
you could be better suited to work for a company with considerably
lower metrics.

There is simply no way to adequately describe the advantages and

drawbacks of parenting for those of you who are not parents but antic-
ipate becoming one in the future. You will never have a career more
gratifying or hard than this one. It is intriguing, unexpected, time-con-
M

suming, taxing and stressful. And that’s only in the initial days follow-
ing the hospital discharge of a child. Leaving aside the times of amaze-
ment and awe, it is also demanding and challenging. Your eyelids may
hurt on some days. There are certain evenings when it is impossible to
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distinguish between the pressures of a job and motherhood. You will

go through restless nights and difficult days.

What then is the lesson of the tale? There is no such thing as a flawless
firm, and anyone who claims there probably just wants to sell you a
bridge and is not trustworthy. The better choices are more in line with
your professional objectives, nevertheless. To discuss your unique
goals and how to develop a custom strategy that meets your needs, get
in touch with one of our knowledgeable recruiters right now.

12.4.7 SELECTING A GROUP

Group interviews are widespread in many professions and save time

for hiring managers. They can be set up in several ways. One appli-
cant may be interviewed by a group of interviewers, or a single inter-
viewer may speak with numerous candidates at once.
 RECRUITING, INTERVIEWING AND SELECTION 411

ACTIVITY

Write some more questions asked in an interview.

12.5 INVESTMENT BANKING

Investment banking is a branch of banking that coordinates massive,
intricate financial transactions like mergers or the underwriting of
Initial Public Offerings (IPOs). In addition to underwriting the issuing
of new securities for a corporation, municipality or other entity, these
banks may raise money for businesses in several other ways. They
might oversee an organisation’s Initial Public Offering (IPO). They will
offer guidance on reorganisations, mergers and acquisitions. Invest-
ment bankers are professionals who are acutely aware of the state of
the market for investments. They assist their clients in navigating the
difficult high finance industry.

S
Investment banks deal with the selling of securities, mergers and
acquisitions, reorganisations and broker transactions for both insti-
tutions and individual investors. They also underwrite new debt and
IM
equity securities for all kinds of firms. Investment banks advise issu-
ers on the offering and placement of stock as well.

The largest include Goldman Sachs, Morgan Stanley, JPMorgan

Chase, Bank of America Merrill Lynch and Deutsche Bank. Numer- NOTE
ous significant investment banking systems are subsidiaries or affili- Investment banking is a type of
ates of bigger financial organisations.
M

banking that organises large,

complex financial transactions
Investment banks often support significant, complex financial trans- such as mergers or Initial Public
actions. If the investment banker’s client is considering an acquisi- Offer (IPO) underwriting.
tion, merger or sale, they could offer guidance on how much a firm
N

is worth and the best way to organise a deal. In addition to these ser-
vices, investment banks may also issue securities to raise funds for
their clientele and prepare the paperwork required by the Securities
and Exchange Commission (SEC) for a firm to go public.

Businesses and institutions turn to investment banks for advice on

how to best plan their development because, in theory, investment
bankers are experts who have their finger on the pulse of the current
investing climate. Investment bankers can tailor their recommenda-
tions to the current state of economic affairs.

SELF ASSESSMENT QUESTIONS

6. Which of the following is a branch of banking that coordinates

massive, intricate financial transactions like mergers or the
underwriting of Initial Public Offerings (IPOs)?
a. Investment banking b. Financial institutions
c. Financial activities d. All of these
412 FINANCIAL MODELLING

ACTIVITY

Find some features of investment banking.

12.6 SELECTION
The two phases of personnel practices and processes, recruitment and
NOTE selection, work in tandem. Any effort required to generate enough
Investment banking is a special applications for a given post so that there is a chance for meaning-
segment of banking operation ful selection constitutes recruiting. Three typical sources are used to
that helps individuals or fill positions: job postings, employment exchanges or private employ-
organisations raise capital and ment agencies and current workers. Additionally, deputations, casual
provide financial consultancy
services to them. They act as
applications, unions and educational institutions are also used. The
intermediaries between security process then moves on to assess each candidate’s background and
issuers and investors and help credentials to make a decision. As has been stated many, selection
new firms to go public. fundamentally involves choosing the employees who are most suited

S
to the organisation’s needs.

Because the selection of unskilled or semi-skilled personnel for cer-

tain professions does not provide many difficulties, a complex selec-
IM
tion process is not necessary. However, a complex selection process
has been recognised to be necessary for supervisory, higher-level and
specialised employment, notably in public undertakings, private firms
and industries and it is now being implemented. Depending on the
context and requirements of the organisation, as well as the level at
which the selection is made, different organisations have different
M

selection techniques and procedures.

In most cases, the selection process will start with a screening inter-
NOTE view and end with the choice to hire. Seven phases typically make
A systematic and accurate
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up the selection process: an initial screening interview, filling out an

occupational information is
necessary before the employees application, employment tests, a complete interview, a background
can be recruited, selected or check, a physical exam and a final hiring decision. Each of these
placed on the job. phases is a decision point that must receive approval for the process
to move forward. Every stage of the hiring process aims to deepen
the organisation’s understanding of the candidate’s background, skills
and motivation and it does so by supplying more data on which deci-
sion-makers may base their forecasts and make their ultimate pick.

Utilising application blanks with pre-structured and pre-determined

questions is a crucial selection approach. Name, residence, age, mar-
ital status, number of dependents, education level, work history and
references are the primary pieces of information sought on applica-
tion blanks. The other fields on the application forms differ greatly
between organisations and jobs.

These application blanks serve the twin purposes of introducing the

applicant and assisting the interviewer by posing questions and spark-
ing conversation.
 Know More
After a complete job analysis,
the planning of a recruitment
programme can be done.
S
422 FINANCIAL MODELLING

4. Candidates must be able to manage unusual situations and

sustain positive client connections. Which of the following
statement is correct regarding the above statement?
a. Entrepreneurial skills
b. Management and leadership abilities
c. Skills in communication
d. Networking skills
5. The interviewer is also paying attention to the session’s schedule
of questions and other details. Which of the following option is
correct regarding the above statement?
a. Plan
b. Pilot test of the schedule
c. Preparation of interview schedule

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d. Conducting the interview
6. An employer and you converse during the interview to share
IM
information. Which of the following option is correct regarding
the above statement?
a. Qualitative/fit questions
b. Technical questions
M

c. General interviewing overview

d. None of these
7. Candidates are evaluated through technical interviews for
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careers in IT, engineering and science. Which of the following

option is correct regarding the above statement?
a. After the interview
b. Technical questions
c. Both a and b
d. None of these
8. The majority of application blanks appear to include
a. Personal information
b. Physical information
c. Both a and b
d. None of these
 RECRUITING, INTERVIEWING AND SELECTION 423

9. Which of the following information is used for application

blanks?
a. They provide the candidate with their official first introduc-
tion to the business.
b. They produce data in consistent forms, making it simple to
cross-compare candidates.
c. The information so produced might be used as the starting
point for an interview discourse.
d. All of these
10. Information provided in the application’s blank can be utilised
for __________.
a. Provide the first introduction
b. Compare candidates
c. Interview discourse
d. Personnel analysis S
IM
12.9 DESCRIPTIVE QUESTIONS
?
1. Describe the concept of recruiting and interviewing?
2. What do you mean by financial institutions?
M

3. Discuss the concept of selection.

HIGHER ORDER THINKING SKILLS

12.10
(HOTS) QUESTIONS
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1. Which of the following is the recruitment’s goal?

a. Verify if the cost and benefit are equal.
b. Decrease the number of candidates who are overqualified or
underqualified for the position to help the selection process
succeed more often.
c. Assist the company in hiring a more ethnically diverse work-
force.
d. None of these
2. Which of these is the most significant outside influence
influencing hiring?
a. Sons of the soil
b. Labour market
424 FINANCIAL MODELLING

c. Unemployment rate
d. Supply and demand
3. Which of the following acts addresses hiring and selecting
employees?
a. Child labour act
b. The apprentice’s act
c. Mines act
d. All of these

12.11 ANSWERS AND HINTS

ANSWERS FOR SELF ASSESSMENT QUESTIONS

S
Topic
Recruiting and Interviewing
Q. No.
1. a.
Answer
Human capital
IM
Financial Institutions and 2. b. Financial activities
Investment Banks

3. c. Financial institutions

Process of Interviewing 4. b. Plan

M

5. a. Pilot test of the schedule

Anything you ever wanted to 6. a. Investment banking

know about investment banking

Selection 7. b. Selection
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ANSWERS FOR MULTIPLE CHOICE QUESTIONS

Q. No. Answer
1. c. Interviewing
2. b. Intellectual abilities
3. a. Analytical skills
4. d. Networking skills
5. d. Conducting the interview
6. c. General interviewing overview
7. b. Technical questions
8. c. Both a and b
9. d. All of these
10. d. Personnel analysis
 CASE STUDIES
10 TO 12

CONTENTS

Case Study 10 Financial Modelling OOVA

Case Study 11 Burke Marketing Services, Inc.
Case Study 12 Which is More Important – Recruiting or Retaining?

S
IM
M
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428 FINANCIAL MODELLING

CASE STUDY 10

FINANCIAL MODELLING OOVA

Problem: Financial estimates based on research and presented in

Case Objective a form that investors can comprehend are necessary for a founder
This case study highlights the seeking to raise a seed round.
financial estimates.
The CEO and co-founder of OOVA, Amy Divaraniya, saw a mar-
ket need for a reproductive diagnosis kit that brought a clinic’s
precision into your house. But while she was attempting to com-
plete her seed round by pitching investors, she discovered that
the financial predictions required a second set of eyes. When dis-
cussing financial estimates, Divaraniya said, “I thought they were
poor. They lacked data to support them. Additionally, it was pre-
sented in a way that I could comprehend, but VCs were not used
to seeing it.

Divaraniya had excellent connections with other start-ups, but

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she was unable to get a quality template. The one thing no one
wants to discuss is that. Even if she did, Divaraniya believed she
lacked the knowledge necessary to base her judgement on facts
and reasonable assumptions. “What might I expect in terms of
IM
legal fee growth? Taxes? How does a CAC for a business like ours
typically look? What makes us different?

Solution: A financial model that is very flexible and logical, with

all of its assumptions supported by research.
M

HOW DIVARANIYA FOUND THE RIGHT CONSULTANT

Divaraniya saw that Toptal also provided financial advice while

working with a Toptal developer in 2018. She came to the conclu-
N

sion that it was time to act, so she started interviewing potential

candidates.

During the interview, Divaraniya picked Jeffrey Fidelman from

a list of two consultants with relevant backgrounds that the Top-
tal matching team had chosen. “With Jeffrey, he recognised my
needs. Have you given these ideas any thought? He would in-
quire. Someone had previously questioned me about everything
he stated, but I hadn’t given it any thought.

He really grasped my needs rather than my requests.

QUICK KICK OFF PROCESS

Fidelman integrated himself into the process right away. “He sup-
plied an example of a financial estimate over the weekend after
the interview, which took place around the end of the week. With-
in a few hours over the weekend, he answered to every message.
Next a launch call on Monday, they spoke at least twice a week
 CASE STUDY 10: FINANCIAL MODELLING OOVA 429

CASE STUDY 10

over the following several weeks. Divaraniya had a functioning

model in around two weeks.

UNDERSTANDING THE BIGGER PICTURE, NOT JUST THE

“ASK”

The initiative may have stopped there, but Fidelman’s further

inquiries revealed more gaps that Divaraniya wished to remedy
with her funding. Divaraniya also came to the realisation that her
model needed flexibility so she could examine the effects of varied
tactics (e.g., various distribution models). Divaraniya spent more
time working with Fidelman than she anticipated since she first
assumed she just needed a simple financial model. In the end, she
had six reports totaling around 25 pages each that supported each
assumption in addition to a highly flexible financial model.

A FLEXIBLE FINANCIAL MODEL

S
Both Fidelman and Divaraniya were still figuring out the ideal
sales channel strategy for OOVA at the time Fidelman was de-
IM
veloping the financing model. We continued to work on product
development at the same time. The sales strategy keeps evolving.
Do we need to charge affiliate fees? One-time costs Jeffrey was
quite adaptable. With the model he developed, we could still make
it work regardless of what I selected. When Divaraniya settled on
a model, Fidelman created an assumptions tab with all the sales
M

techniques she was contemplating so she could just put them in.

MARKET RESEARCH TO CREATE FACT-BASED FINANCIAL

MODEL INPUTS
N

The quality of your model depends on its inputs. Fidelman sought

to produce a model that was as accurate to the business as fea-
sible. The topline numbers required considerable investigation;
however the expenditure side was rather simple. Fidelman used
his network to get answers to inquiries like: What is the typical
markup? What is the US fertility market size? “Yes, it’s consumer
items as well as health technologies. So a lot of my study included
things like heart rate monitoring, baby monitors and birth con-
trol, said Fidelman.

Fidelman conducted research on OOVA’s distinctive market posi-

tion. “Yes, it is tech-enabled. However, as they are still ovulation
sticks, you’ll probably need to replace them. Where can I get this
OTC? Would it fall under the heading of “Personal Care/Family
Planning”? Will the pharmacy’s front desk have it? We had to give
the people we wanted to sit with some serious thought.
430 FINANCIAL MODELLING

CASE STUDY 10

RESULTS

OOVA was able to close its seed round with the help of a flexible
finance strategy built on extensive market research.

Divaraniya was able to complete her seed funding round with the
use of a flexible financial model and market analysis. “Discussions
with investors were a lot simpler. I felt like I could firmly stand on
my own two feet while fundraising.

QUESTIONS

1. Discuss the market need for a reproductive diagnosis kit.

(Hint: The CEO and co-founder of OOVA, Amy Divara-
niya, saw a market need for a reproductive diagnosis kit
that brought a clinic’s precision into your house)

S
2. Discuss the quick kick off process in this case study.
(Hint: Fidelman integrated himself into the process right
away. “He supplied an example of a financial estimate
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over the weekend after the interview)
M
N
 CASE STUDY 11: BURKE MARKETING SERVICES, INC. 431

CASE STUDY 11

BURKE MARKETING SERVICES, INC.

Burke is a full-service marketing research and decision support

firm that was founded in 1931. Burke uses cutting-edge research Case Objective
execution, innovative analytical approaches and cutting-edge This case study demonstrates
technology to give decision support solutions to businesses in all how Burke’s experimental
major industries. Burke provides a comprehensive range of re- design and subsequent
search services. analysis of variance aided
in making a product design
Burke Marketing Services, Inc. is one of the industry’s most sea- recommendation.
soned market research businesses. Every day, Burke writes more
proposals for more projects than any other market research firm
around the globe. Burke has a comprehensive range of research
capabilities, backed by cutting-edge technology and can answer
practically any marketing query.

Burke was hired by a company to analyse possibly new versions

S
of a children’s dry cereal in one research. The cereal producer is
referred to as the Anon Company to maintain anonymity. The fol-
lowing were the four important characteristics that Anon’s prod-
uct creators believed would improve the cereal’s taste:
IM
1. Wheat-to-corn ratio in cereal flakes
2. Sweetener type (sugar, honey or artificial)
3. The presence or absence of fruit-flavoured flavour particles
4. Cooking time (short or lengthy)
M

Burke devised an experiment to see how these four elements af-

fected cereal flavour. One test cereal, for example, was created
with a specific wheat-to-corn ratio, sugar as the sweetener, fla-
vour bits and a short cooking time; another test cereal was made
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with a different wheat-to-corn ratio but the other three elements

remained the same and so on. The cereals were then tasted by
groups of children, who gave their opinions on how they tasted.
Burke employs taste tests to gather statistical data on what people
desire from a product. The statistical method utilised to analyse
the data from the tests was an analysis of variance. The investiga-
tion revealed the following:

Flake composition and sweetener type had a significant impact

on taste evaluation. The flavour pieces detracted from the cere-
al’s taste. The taste was unaffected by the cooking duration. This
knowledge aided Anon in determining the parameters that would
result in the best-tasting cereal. Burke’s experimental design and
subsequent analysis of variance were useful in coming up with a
product design recommendation
Source: [Link]
Business%20and%20Economics%20(2011)/14.%20Chapter%2013%20%20Experimen-
tal%20Design%20and%20Analysis%20of%[Link]
432 FINANCIAL MODELLING

CASE STUDY 11

QUESTIONS

1. Discuss the found year of Burke Marketing Services, Inc.

(Hint: Burke is a full-service marketing research and
decision support firm that was founded in 1931)
2. Describe the business of Burke Marketing Services, Inc.
in this case study.
(Hint: Burke Marketing Services, Inc. is one of the indus-
try’s most seasoned market research businesses. Every
day, Burke writes more proposals for more projects than
any other market research firm around the globe)

S
IM
M
N
 CASE STUDY 12: WHICH IS MORE IMPORTANT – RECRUITING OR RETAINING? 433

CASE STUDY 12

WHICH IS MORE IMPORTANT – RECRUITING OR

RETAINING?

An innovative and well-known company in the electronics sec-

tor is Uptron Electronics Limited. It lured workers by providing Case Objective
high salaries, benefits and other incentives from internationally This case study highlights
renowned institutions and enterprises. An electronics Engineer the comparison between
vacancy has recently been advertised. There were around 150 recruiting and retaining.
applicants for the position. The 130 applicants who participated
in exams and interviews were narrowed down to Mr. Sashidhar,
an electronics engineering graduate from the Indian Institute of
Technology with five years of work experience in a medium-sized
electronics company. At his request, the interview panel suggest-
ed that his compensation be increased by 5,000 over his current
income. Mr. Sashidhar was overjoyed to have done this and re-
ceived congratulations and good luck wishes from many people,

formance.

S
including his former company, for his outstanding interview per-

Mr. Sashidhar enthusiastically joined Uptron Electronics Ltd. on

IM
January 21, 2002. Additionally, he thought working for this organ-
isation in the early stages of his career was respectable. He also
thought his job was pretty pleasant and difficult. Both his super-
visors and his subordinates, in his opinion, were kind and helpful.
However, this climate was short-lived. After serving for a year, he
gradually learned about a variety of unfavourable tales about the
M

business, the management, the relationships between superiors

and subordinates and the rate of employee turnover, particularly
at higher levels. However, he decided to remain because of the
promises he made to the management during the interview. By
performing diligently, firmly committing to his commitment and
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devoting himself, he hoped to win the management’s favour and

alter its attitude. The management believed Mr. Sashidhar had
made a commitment to the firm and had settled down when he
began to maximise his efforts.

After a while, Mr. Sashidhar began to feel disrespected by his su-

periors. He had too many different duties to do. It limited his abil-
ity to make decisions and carry them through. He was mistreated
in front of his subordinates on several occasions. His co-workers
began entrusting Mr. Sashidhar with their duties as well. As a re-
sult, his social, professional and familial lives were out of balance.
He appeared to be pleased and at peace, though. The manage-
ment team believed that Mr. Sashidhar could handle a lot more
organisational responsibility.

The General Manager was therefore taken aback when he dis-

covered Mr. Shashidhar’s resignation letter and a check for one
434 FINANCIAL MODELLING

CASE STUDY 12

month’s salary one lovely morning on January 18, 2004, in his of-
fice. Mr. Sashidhar was not persuaded to rescind his resignation
by the general manager. On January 25, 2004, the General Man-
ager terminated his employment. The General Manager initially
intended to form a committee to investigate the situation right
away, but shelved the proposal.

QUESTIONS

1. Discuss the interview panel suggested about the compen-

sation in this case study.
(Hint: The interview panel suggested that his compensa-
tion be increased by 5,000 over his current income)
2. Discuss the joining date of Mr. Sashidhar.
(Hint: Mr. Sashidhar enthusiastically joined Uptron Elec-

S
tronics Ltd. on January 21, 2002)
IM
M
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