VI-Finance-Financial Modelling For Corporate...

FINANCIAL MODELING

FOR

CORPORATE VALUATION

Prepared by

VIJAY MAHAWAR

14PGGMS071

Presented to

Sri Sri University, Cuttack, Odisha

2014-2016 BATCH

2 FINANCIAL MODEING FOR CORPORATE VALUATION

CAPSTONEProjectReport

PreparedbyVIJAYMAHAWAR(14PGGMS071)

DECLARATION BY THE LEARNER

This is to declare that I have carried out this project work myself in part fulfillment of the

Trimester VI of MBA program in General Management from Sri Sri University, Cuttack,

Odisha.

The work is original, has not been copied from anywhere else and has not been submitted to

any other University/Institute for an award of any degree/diploma.

Date: 28th March, 2016 Signature:

(VIJAY MAHAWAR)

Place: Sri Sri University, Cuttack, Odisha




TABLE OF CONTENTS

CHAPTER 1: INTRODUCTION........................................................................................................6

CHAPTER 2:EXCEL AS A MODELING TOOL..............................................................................7

CHAPTER 3: BLOOMBERG MARKET CONCEPTS......................................................................8

CHAPTER 4: ABSOLUTE VALUATION.........................................................................................9

Step1:Estimatelong-termfuturecashflowsbasedonassumptions..............................................9

Step2:Estimatediscountrateaka“WACC”..................................................................................10

Step3:Discounttheestimatedfuturecashflowsby“WACC”.......................................................11

Step4:TaketotalfirmvalueandderiveMarketCapitalization.....................................................11

Step5:Calculatetheshareprice....................................................................................................12

CHAPTER 5: RELATIVE VALUATION........................................................................................13

CHAPTER 6: ABSOLUTE VALUATION VS RELATIVE VALUATION....................................14

CASE STUDY: FMCG SECTOR.....................................................................................................14

Exhibit:BalanceSheetAssumption............................................................................................23

Exhibit:RevenueAssumption....................................................................................................24

Exhibit:AssetScheduleAssumption..........................................................................................26

Exhibit:FinancingAssumption...................................................................................................26

Exhibit:TaxandValuationAssumption......................................................................................26

Exhibit:RevenueBuildUp..........................................................................................................27

Exhibit:CostBuildUp.................................................................................................................28

Exhibit:DebtSchedule...............................................................................................................29

Exhibit:AssetSchedule..............................................................................................................30

Exhibit:BalanceSheet................................................................................................................31

Exhibit:Profit&Loss..................................................................................................................32

Exhibit:CashFlow......................................................................................................................33

Exhibit:RatioAnalysis................................................................................................................34

Exhibit:Valuation.......................................................................................................................35

Exhibit:Comps...........................................................................................................................36

APPENDIX I: REFERENCES..........................................................................................................37

APPENDIX II: BLOOMBERG TERMINAL CODES......................................................................38




CHAPTER 1: INTRODUCTION

Financial modeling is the task of building an abstract representation (a model) of a real world financial situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio of a business, project, or any other investment.

The process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterized by performing calculations, and makes recommendations based on that information. The model may also summarize particular events for the end user and provide direction regarding possible actions or alternatives.

Financial models can be constructed in many ways, either by the use of computer software, or with a pen and paper. What's most important, however, is not the kind of user interface used, but the underlying logic that encompasses the model. A model, for example, can summarize investment management returns, such as the Sortino ratio, or it may help estimate market direction, such as the Fed model.

In corporate finance, investment banking, and the accounting profession financial modeling is largely synonymous with financial statement forecasting. This usually involves the preparation of detailed company specific models used for decision making purposes and financial analysis. Applications include: • Business valuation, especially discounted cash flow, but including other

valuation problems • Scenario planning and management decision making ("what is"; "what if";

"what has to be done") • Capital budgeting • Cost of capital (i.e. WACC) calculations • Financial statement analysis (including of operating- and finance leases, and

R&D) • Project finance • Mergers and Acquisitions (i.e. estimating the future performance of

combined entities)




CHAPTER 2:EXCEL AS A MODELING TOOL

• Excel is one of the most widely used tools in financial industry

– Easy to use

– High reach & access to software across geographies

– Flexibility

– Robustness

– Inbuilt features (Most people would not even be using 95% of the features) & Extendibility

– Modular and Object Oriented Architecture

• Excel as a data-store

– Easy to store and retrieve information

– Flexibility to put many data-types in the same sheet

• Functions and a range of features

– Excel is easily extendible to be used as a Modeling tool

• Modeling Context

– Understand the industry models being used

– Create your own models Rather than just using them

– Improve & enhance productivity in work

– Extend these models for your use

– Debug Problems




CHAPTER 3: BLOOMBERG MARKET CONCEPTS

AN INTRODUCTION TO FINANCE FROM BLOOMBERG.

Bloomberg Market Concepts (BMC) is an 8 hours self-paced e-learning course that provides a visual introduction to the financial markets. BMC consists of 4 modules –

1. Economics, 2. Currencies, 3. Fixed Income and 4. Equities

The modules are woven together from Bloomberg data, news, analytics and television.




CHAPTER 4: ABSOLUTE VALUATION

An absolute value is a business valuation method that uses discounted cash flow analysis to determine a company's financial worth. The absolute value method differs from the relative value models that examine what a company is worth compared to its competitors. Absolute value models try to determine a company's intrinsic worth based on its projected cash flows.

• Absolute valuation involves the discounting of future cashflows. • The discount rate is higher for long-term cashflows and for riskier firms. • Good financial models balance simplicity with insights. • Absolute valuation is theoretically perfect. • Absolute valuations are usually precisely wrong.

The five steps involved in valuation using Absolute valuation are:

Step1:Estimatelong-termfuturecashflowsbasedonassumptions




Step2:Estimatediscountrateaka“WACC”




Step3:Discounttheestimatedfuturecashflowsby“WACC”

Step4:TaketotalfirmvalueandderiveMarketCapitalization




Step5:Calculatetheshareprice.

5 steps process in valuation summarized.




CHAPTER 5: RELATIVE VALUATION

A relative valuation model is a business valuation method that compares a firm's value to that of its competitors to determine the firm's financial worth. Relative valuation models are an alternative to absolute value models, which try to determine a company's intrinsic worth based on its estimated future free cash flows discounted to their present value. Like absolute value models, investors may use relative valuation models when determining whether a company's stock is a good buy.

P/E Ration Benchmarking:

1. Itself 2. Its Peers 3. The Market

• Relative valuation is the quick and easy comparison of one valuation to

another • The risk of relative valuation is being led astray by unrealistic reference

points • Earnings and multiples are used to estimate fair share prices • Fast growing companies warrant high multiples and vice versa. • The state of the economy is a key driver of relative valuation.




CHAPTER 6: ABSOLUTE VALUATION VS RELATIVE VALUATION

CASE STUDY: FMCG SECTOR

Looking through the window of his office, Akshay was wondering how quickly time has passed by. The day was pleasant with bright sunshine outside. With a mug of coffee in his hand, he was looking at the day to day activities in the premises of Renuka Consumer Products Limited (“RCPL”).

Akshay had just completed his MBA when his father expired in late 2004. Since then he had taken control of RCPL, a company started by his father and named after his mother Mrs. Renuka Devi.

RCPL, a popular name in one of the western states of India, operates in fast moving consumer products segments. It manufactures and sells three products:

• Soapsinpacketsof100gms• Haircolourinbottlesof250ml• LiquidDetergentsinthebottlesof500ml

Since the time Akshay took control of the operations at RCPL, the company has grown leaps and bounds. The volumes sold across each of the three categories of products have shown significant growth over last five years.




Exhibit 1: Volumes sold over FY05 – FY09

Besides, RCPL has also managed to consistently increase the sale prices of its products primarily because of lack of competition in the areas where it has achieved good marketability.

Exhibit 2: Sales Price Movement

However, Akshay knows that things are no longer going to be as comfortable as they are right now. Specially, in a situation when a leading listed player in the consumer products area has announced plans to expand in the geographies where RCPL operates. Given the changing dynamics of the business, Akshay was thinking through the potential course of actions he can take to counter the increasing competition. As a first step he decided to take stock of the situation. He asked the chartered account for the historical financial statements of the company.

Exhibit 3: Historical P&L Statement of RCPL




Exhibit 4: Historical Balance Sheet of RCPL




While the past performance looked phenomenal, he knew that he along-with his management team has to constantly improve and think ahead of curve lest RCPL should be eaten by the competition. He was well aware of the fact that however good his team might be, past performances may not be sustained in future unless he does plan well in advance. He quickly summoned his Sales and Marketing team to seek their inputs on the future sale price points for the various products RCPL manufacture.

Excerpts from the discussion he had with his Sales & Marketing team:

“....Soap segment has seen a high growth phase so far, but due to enhanced penetration in the rural markets, this segment will see a tapering growth rate from the expected 15% in FY10 to 12% in five years time. Due to lack of fashion consciousness in the villages, hair colour segment will, at the best see a CAGR of 0.5% less than historical CAGR over a five period time frame. ..Liquid detergents have gained popularity in the rural markets and will continue to display a growth rate of 5% - 6% over the same time frame, very much in line with its growth rate last year...”

“....While RCPL has so far controlled the sale prices of these products at its will, the same may not happen in future. It will be almost impossible to increase the prices of soaps and detergents for the next two years and even beyond that, the increase will be limited to 2% to 3%. Hair colour segment still has a possibility of seeing a price CAGR growth rate same at historical levels...”

Akshay quickly realized that in the competitive world, revenue growth alone may not fetch the desired shareholders’ value creation. He quickly turned his attention to the key cost elements in the P&L statement. He knew that raw material was the key constituent of the total cost base. There were just four categories of raw materials required for the operations of RCPL.

Exhibit 5: Raw materials requirement of key products of RCPL

Acids were the single primary key raw material in terms of quantum of consumption. Specialty chemicals were added to achieve the desired colour and perfumes were added for fragrance. Akshay quickly noticed the raw materials price trend from the exhibit overleaf provided to him by the Materials Department




Exhibit 6: Raw Materials Price movement

He quickly invited Mr. Rao, Head of Materials Department for a discussion on the prices of the raw materials.

Excerpts from the discussion he had with Mr. Rao

“...For the acids, RCPL has entered into a long term contract with the leading supplier in the region. Under the terms of the contract, acids will see a price escalation of constant 5% every year for the next five years. For specialty chemicals, he has multiple vendors and due to high bargaining power RCPL enjoys with the suppliers, the price rise in this segment will be restricted to 5% every year. Ordinary chemicals will display a price rise of 15% to 16% over the same time horizon while perfumes will display the historical CAGR in terms of its price growth...Power cost will display a growth rate in the range of 10% – 11%...”

As soon as the discussion was concluded and Mr. Rao left the room; a very commanding and authoritative female voice shouted at him, “You never seem to keep track of time. It’s lunch time, where had you been?”

From the authority and power in the voice, it was evident that the voice was of none other than Raveena, Akshay’s wife. Raveena was Akshay’s childhood friend and was also his father’s choice as his wife. The two got married in early 2005 when Akshay took control of RCPL and Raveena of Akshay. A wife’s entry into the scene need not always be welcome when one is thinking about the future, however this time Raveena’s entry was perfect in time. Raveena, besides being Akshay’s wife, was also the HR head of RCPL. Over lunch, Akshay figured out that his HR department had been quite cautious in growing the manpower in the organization.

Exhibit 7: Manpower in RCPL

Raveena told him that manpower count will remain the same for this year while she had budgeted a headcount increase of 5% beyond. Knowing that he must be thinking of the cost control, she anticipated his next question, thus displaying a quality rare in HR and provided information on the monthly salary figures of the employees in different categories.




Exhibit 8: Average monthly salary

She also indicated that the employees have not received any salary hike this year; however she had budgeted for 5% hike year on year for the next five years. The firm will continue to pay 15% of the salary as bonus in the years to come unless something unforeseen happens. The two had finished lunch, post which she left the room without any debate; something you won’t expect at least from an HR professional who has been queried about the “resources”.

Post lunch, it was time for a quick walk and he was joined by none other than Mr. Tibrewala, the guy behind the operations of RCPL. Akshay was aware that the packaging of the end products of RCPL was outsourced to another firm through a long term contract. Mr. Tibrewala clarified that packaging cost will see a meager rise of 2% after remaining constant this year (with respect to FY09). Besides, he promised to mail Akshay the historical packaging rates.

At times, our mailbox is so flooded with mails that we simply keep staring at it without knowing which ones to open first. But Akshay was quite clear in his mind and he clicked open the mail from Mr. Tibrewala as soon as he reached his office after the walk.

Exhibit 9: Packaging cost per unit

Akshay knew that RCPL had not been an aggressive advertiser so far. However, in order to increase penetration of the products and reach wider markets, advertisement-spend had to increase. He has increased the budgetary allocation of advertising spend to 10% of sales this year and he decided to raise it to ~ 14% gradually over next few years. Besides to prevent the retailers and salesman from partnering with any new player in the area, he knew he would have to gradually increase their commission to 7% from the current levels of 5%.

Having been through key items of revenues and growth, it was now time to interact with Corporate Finance department about the future capital expenditure and their funding plans. The firm had raised a debt of Rs. 500 Lakhs at an interest rate of 12% in FY05 to be repaid in 20 equal installments beginning FY06. The capital expenditure plans for the firm was as follows




Exhibit 10: Capital expenditure plans

The firm depreciated all capex items using a straight line method over a period of 10 years. Knowing the cash balance available with RCPL and good results so far in FY10, he realized that no additional external funding will be required in order to carry out the planned expansion.

Having assimilated all the information now, Akshay was now wondering how to make use of them to figure out the cash position of the company, its financial health and projected performance. He was also thinking of a possible way of arriving at the valuation of the company his father had created. He knew that he had a tough task in his hand. He was reminded of an investment banker, Christopher, his batch mate from his MBA College. However, he did not want to employ his services as he feared the magnitude of the fees. Eventually, he called him to seek information on trading multiples of the listed companies in this sector and also an update on the recent M&A or PE transactions that might have happened.

Gone are the days when investment bankers used to be working 100 hours a week. Thanks to the recent downturn, bankers now enjoy some free evenings with their loved ones. However, greed for fees never leaves them. Within minutes of the call, Akshay saw a mail from Christopher who has concisely compiled the data he was looking for.

Exhibit 11: Trading multiples of the listed companies in FMCG sector

Note: *EV and M Cap in Rs. Lakhs




Exhibit 12: Transaction Multiples

Akshay has a voluminous and strenuous task at hand to determine the value of his firm. However, he had been quick to break a big problem into a series of smaller problems to facilitate his task.

Step 1:

As a first step, prepare cash flow statements from the historical P&L and Balance sheet statements for the period of FY05 to FY09

Step 2:

Identify key drivers of the revenue and cost. Prepare projected financial statements based on the historical trends and the inputs gathered from various departments.

Step 3:

Based on projected financial statements, build a DCF model to arrive at an approximate equity value of the firm. Examine this valuation with respect to the trading multiples and transaction multiples in the industry.




Exhibit:BalanceSheetAssumption




Exhibit:RevenueAssumption




Exhibit:CostAssumption




Exhibit:AssetScheduleAssumption

Exhibit:FinancingAssumption

Exhibit:TaxandValuationAssumption




Exhibit:RevenueBuildUp




Exhibit:CostBuildUp




Exhibit:DebtSchedule




Exhibit:AssetSchedule




Exhibit:BalanceSheet




Exhibit:Profit&Loss




Exhibit:CashFlow




Exhibit:RatioAnalysis




Exhibit:Valuation




Exhibit:Comps




APPENDIX I: REFERENCES

1. Financial Modeling definition: https://en.wikipedia.org/wiki/Financial_modeling 2. URL (video): https://vimeo.com/133348600 3. URL (About BMC): http://about.bloomberginstitute.com/bloomberg-market-

concepts/ 4. Financial Modeling material (case study) from Pristine –

http://www.edupristine.com




APPENDIX II: BLOOMBERG TERMINAL CODES

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