Financial Modeling:

PRESENTED BY
SMITA GUPTA
RAJVI SINGHI
SNEHA RAJARAM
SMRITI JAIN
SHUBHAM AGARWAL
 Introduction
Financial modeling is the task of building an abstract
representation (a model) of a financial decision making
situation.
[1] This is a mathematical model designed to represent (a
simplified version of) the performance of a financial asset
or a portfolio, of a business, a project, or any other
investment
[2] financial modeling is synonymous with cash flow
forecasting.
[3] This usually involves the preparation of large, detailed
models, which are used for management decision making
 Contd.
• Application Include:
–Business valuation, especially discounted
cash flow, but including other valuation
problems
–Capital budgeting
–Cost of capital or WACC
–Financial statement analysis
–Project finance
Process Of Financial Modeling
 Steps in Financial Modeling
• Feasibility Study
• Model construction
• Compatibility of the model with the tools used
• Model validation
• Model implementation
• Model review and update
• Documentation
 Validating Financial Models

• Create a Framework for Ensuring the Development of

Valid Financial Models
• Decompose Financial Model Validity into Selected
Components in Order to Facilitate Better Model
Development
• Consider How You Can Build More Valid Models
• Apply Spreadsheet Auditor Software Capability to Your
Existing Model
• Explore How Colleagues in Other Organizations
Validate Their Financial Models
 Financial decisions - Leverage
• Break Even Analysis :
– Break even sales is also referred to as a point where total revenue and
total cost coincides & after this point profit starts occurring.
– Variable costs are expected to change at the same rate as the firm’s
level of sales.
– VC are constant per unit, so as more units are sold the total variable
cost also rises. E.g.: Sales commission, costs of raw materials etc
– Fixed costs are those costs that are constant regardless of the quantity
produced, over some relevant change of production.
– Total FC per unit will decline as the no. of units increases. E.g.: rent,
salaries etc
– Mathematically,
BEP = Fixed Costs
Sales- Variable costs
Limitations of Break even Analysis:
• Costs Segregation

• Assumption with regard to consistency in Fixed costs

• Assumption with regards to consistency in Revenue and Variable
costs.
• Assumptions with regard to a multi- product firm

• Financial Break even point

 Types of Leverage

Operating Leverage:
• Operating leverage refers to the use of fixed cost in the operation
of a firm and it increases or decreases the firms operating profit
(EBIT) with the change in sales.
• Mathematically, it can be given as;
 DOL = % change in Operating Profit
% change in sales
OR
 DOL = Contribution
EBIT
Financial Leverage:
• The use of fixed charges such as debt and preference capital along
with the owner’s equity in the capital structure, is described as
financial leverage.
• The financial leverage employed by the company is intended to
earn more on the fixed charges funds than their costs.
• It can be defined as a measure to gauge the changes in EPS
because of the change in EBIT due to fixed financial interest charge.
• A company can raise funds from various sources which can be
categorized as:
– Those sources which involve fixed interest charge
– Those sources which do not involve fixed interest charge
• Mathematically, its given as;
DFL = % change in EPS
% change in EBIT
Combined Leverage:
• The degrees of operating and financial leverages can be combined
to calculate the effect of total leverage on EPS associated with a
given change in sales.
• The degree of combined leverage (DCL) is given by the following
equation:
DCL = % change in EPS
% change in sales
• Illustration:
A company known as Vikas Limited planned to invest 8 lakhs. It
expected a sales of 20 lakhs. The selling price p.u. of a product was
Rs. 10 and the variable cost p.u. was Rs. 5. The fixed cost of the
company for the year is expected to be around 5 lakhs. The
company’s D/E ratio is 40:60. The interest on debt is at 10%. The
management of the company wants to know the resultant affect of
25% increase in sales on the EPS of the company. Each share of the
company has a face value of Rs. 100. Tax rate is 35%
 Base Increase of 25% in sales
Total capital employed 800000 800000
Ratio of debt in capital structure 40% 40%
Debt 320000 320000
Equity 480000 480000
Sales in unit 200000 250000
Selling price per unit 10 10
Variable cost per unit 5 5
Revenue 2000000 2500000
Variable cost 1000000 1250000
Fixed cost 500000 500001
EBIT 500000 749999
Interest on debenture 32000 32000
EBT 468000 717999
Tax 163800 251299.65
Earning after taxes/PAT 304200 466699.35
No. of shareholder 4800 4800
EPS 63.375 97.22903125
% change is sales 0.25
% change in EBIT 0.499998
% change in EPS 0.534185897
Degree of FL 1.068376068
Degree of OL 1.999992
Combined leverage 2.13674359
Leverage and Risks:
Leverage magnifies the EPS and also tends to increase its variability
which leads to two types of risks:
1. Operating Risks:
a) Defined as variability of EBIT which results from changes in the
environment which are beyond ones control
b) A firm with high fixed costs will be largely affected than the
firm which has less fixed costs and high variable costs
c) It is an unavoidable risks
2. Financial Risks:
a) The variability of EPS because of the use of financial leverage is
called financial risks
b) It is an avoidable risks - by not employing any debt or external
finance in the company’s capital structure
Financing Decisions

Capital Structure
 Flow Of Discussion
• Meaning Of Capital Structure

• EBIT-EPS Analysis – Significance of Leveraging

• Calculation Of Indifference point

• Capital Structure Theories

 Capital Structure
• Relates to a firms decision to divide its cash flows into two
broad components:
-Debt
-Equity

• Influences Shareholders Return and Risk

• Helps management in deciding the optimum financing mix

 EBIT-EPS Analysis (Using Excel)
• Using Financial Leverage Increases the EPS when the
Economic Conditions are very good.

• Also using high debt percentage when the economic

conditions are very poor erodes shareholders wealth each
year. (E.g. Plan 4 with 75% debt)

• Option of No Debt is the best if not sure of future economic

conditions
 Indifference Points
• A point where EPS of two Financing Plans remains the same
despite differences in their capital structure composition

• The Formula to find the Break even level of EBIT (with

different compositions):

(1-T)EBIT = (1-T)(EBIT-Interest)
No of shares (N1) No of Shares in plan 2
 Capital Structure Theories
• Net Income Approach

• Net Operating Income Approach

• Modigliani-Miller Approach

• Traditional Approach
 Working capital Management
• To run day-to-day business activities
• Determinants
1. Nature of business
2. Production cycle
3. Business fluctuation
4. Credit availability
 Case Study on Cash Budgeting

• Cash budgting.xls
• CASE STUDY FM.docx
 Cash Management Strategies
• Decrease cash conversion cycle
• Stretching accounts Payable
• High Inventory turnover
• Decentralize Collection system
• Lock box system