Financial Modelling (Corporate finance)

BHARATI BURAGOHAIN 4109009009

Capital Asset Pricing Model

The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The model: Es = Rf + (Rm Rf)s

Inputs Output

Risk free rate of return, risk premium Return on market security Market beta=sensitivity to market risk for the security

Expected return for a security

Assumptions of the model

Investors have diversified portfolio Investors can borrow and lend at Rf. Perfect capital market The model assumes that there are no taxes or transaction costs
Managerial Implications

Helps in finding the return on securities /portfolios. Helps in identify the values of securities whether they are over valued or under valued. Help in finding the relation between risk and return.

The dividend growth models

To calculate the value of equity shares under assumptions i.e expected growth pattern of future dividend & appropriate discount rate
Gordan Constant growth model:
V = D0(1+g)/(Ke g)

Inputs: (a) expected future dividends, (b) constant dividend growth rate ( c) discount rate Output: value of the equity Assumptions: (a) dividend payout ratio is constant (b) dividend grow at a constant rate, growth rate = return on equity * retention ratio (e)all equity firm & no external financing (g) no taxes (h) cost of capital greater than growth rate

Two stage growth model

This model is used when dividends are expected to grow at a super normal growth, g, for n years & there after at perpetual growth rate from n+1 yr. Inputs: (a) length of high growth rate (b) expected growth rate in earnings in high growth rate period & stable period ( c) dividend payout ratio during high growth period & stable period (d) current earning per share (e) inputs of cost of equity Outputs: value of equity in the firm

Assumptions: (a)firm is expected to grow at a higher growth rate in the 1st period (b) growth rate will fall down to a stable rate (c ) dividend payout ratio is constant. Managerial Implication:

Growth Models: Internal growth rate: Max. growth which a firm expect, in terms of sales or assets without external financing. Inputs: return on assets, retention ratio Output: internal growth rate Assumption:
EBT varies in direct proportion to its sales Firm has a target dividend payout ratio or retention ratio it wants to maintain,

Managerial implication: help in company to know how much loss the company can bear.
Fund towards working capital.

Sustainable growth rate Max. growth rate ate which the firm can grow using debt & equity without changing its mix. Inputs: return on assets, retention ratio, return on equity. Output: sustainable growth rate. Managerial implication: can set sales growth goals. If actual growth rate is higher that sustainable growth rate the company can borrow external financing(sell equity or borrow debt) Assumptions: target capital ratio, firm dont intend to issue equity.

Linear/integer Programming Approach to capital rationing

This approach is used when a firm has to choose that package of projects which gives maximum total NPV, subject to firms resources. Inputs: NPVs of different projects, constraints(eg: projects not exceeding a certain amount) Outputs: optimal solution,i.e combination of those projects which gives maximum return Assumptions: Future investment opportunities are known. Managerial implications: when companies have shortage of funds they go for choosing the profitable projects

RISK ANALYSIS in capital budgeting

Certainty equivalent Approach

This approach is used when firms forecast c/fs to some conservative levels Inputs: the expected cash flows(without risk adjusted), risk adjusted factor or the certainty equivalent coefficient, risk free rate of interest(constant for all periods), duration Output: NPV(risk adjusted) Managerial implication:

Sensitivity Analysis It is a way of analysing change in the projects NPV(IRR) for a given change in one of the variables. Inputs: variables which impacts NPV/IRR of any project & relation between these variables Output: analysing the impact of change in each of the variable & there after the NPV/IRR is calculated. (these are analysed under pessimistic/expected & optimistic) Assumptions: variables are not inter-related. Managerial Implication:forecast of various variables(sales/investment/ depreciation/tax etc) & to know whether there will be any change in NPV/IRR., helps to expose inappropriate forecasts

Decision tree Approach It is a graphical display to find out the relation between present decision & future events, future decisions & their consequences. Inputs: investment proposals, projected cash flows, probability distributions, expected PVs, etc Output: effective return Managerial Application: used by firms to choose the best of the options

Rate that a company is expected to pay on average to all its security holders to finance its assets. Inputs: cost of debt/equity, % of debt/equity to be used, tax rate Outputs: cost of capital Assumptions: Managerial Implications: helps in capital budgeting decisions.

WACC-Weighted Average Cost of Capital

Capital structure
Net Income Approach

Value of the firm = value of equity + value of debt

Discounted value of shareholders earnings(net income) Inputs: cost of equity, cost of debt, net income, interest, net operating income Output: value of the firm Assumptions: no constant cost of equity Managerial implication: to find out the relation between the capital structure & value of the firm (firms main objective is to maximize the firms value

Modigliani-Miller theory
Without taxes Proposition I: Vu (value of unlevered firm)= Vl (value of levered firm) Proposition II: Ke = ko + D/E(ko kd) - ke is the required rate of return on equity, or cost of equity -k0 is the company unlevered cost of capital (ie assume no leverage). -kd is the required rate of return on borrowings, or cost of debt -D / E is the debt-to-equity ratio. Assumptions no taxes exist, no transaction costs exist, and individuals and corporations borrow at the same rates. With taxes Proposition I: Vl = Vu + TcD -VL is the value of a levered firm. -VU is the value of an unlevered firm. -TC is the tax rate (TC) x the value of debt (D) -the term TCD assumes debt is perpetual

 Proposition II:

re = ro + D/E(ro rd)(1 Tc)

-rE is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium -r0 is the company cost of equity capital with no leverage(unlevered cost of equity, or return on assets with D/E = 0). -rD is the required rate of return on borrowings, or cost of debt -D / E is the debt-to-equity ratio. -Tc is the tax rate. Assumptions -corporations are taxed at the rate TC on earnings after interest, -no transaction costs exist, and -individuals and corporations borrow at the same rate Managerial Implications: it provides a clue about what is required for cap. Structure to be relevant & hence affecting the firms value.

The Trade off theory

Value of levered firm = value of unlevered firm + PV of tax shield PV of financial distress Inputs: after tax net operating income, cost of equity of the unlevered firm, corporate tax rate, interest, cost of debt of the levered firm, cost of insolvency, indirect costs( claims by creditors, employees become demoralised, low demand, inability to raise funds from investors,etc) Output: value of the levered firm Managerial implications: when firm has to choose the best combination of debt & equity in its cap. Structure based on their position in the market, competitiveness in the market

Valuation Approaches 1. DCF Approach: it states value of a firm depends on its expected cash flows & the discount rate. Input: discount rate(generally WACC), cash flows to the firm, current stock price,current dividend & expected dividend growth rate. Output: value of the firm(i.e value of its debt & equity) Assumption: debt ratio remain constant throughout. Managerial Application: to find out the after tax cash flows available to cater to all investors of the firm.

2.Comparative firms valuation approach Key relationships are calculated for a group of similar companies or transaction as a basis for valuation of the firm Inputs: comparable firms based on products, size, age, growth, profitability trends, various ratios of the firms & financial indicators etc Output: value of the firm on the basis of EBIT, free cash flows Assumptions: no assumptions Managerial implications: during M&As, joint ventures, takeovers, etc this approach is used.

3.Balance sheet approach

Assets & liabilities are analysed to determine the value of the firm.

Inputs: book value of equity & debt, current or replacement cost of the assets, brand equity, value of fixed asset based on some bench mark prices. Etc Output: value of the firm Assumptions: no Managerial implications: during M&As.

Dividend Theory Walters model

It shows the relationship between firms rate of return & cost of capital on determining its dividend policy which will increase its wealth of shareholders. Inputs: dividend, cost of capital, earning per share, firms rate of return. Output: market price of its share

Assumptions:
Firm finances all investment through retained earnings Constant rate of return & cost of capital 100% dividend payout Constant EPS & DIV Infinite time.

EOQ (inventory management)

Inputs: ordering cost, carrying cost of inventory, total quantity purchased in a month or a year Output: economic ordering quantity Assumptions: The firm knows with certainty the annual usuage or demand of the particular items of the inventories The rate at which firm use inventories The order of the replenishment of inventory are placed exactly when inventory reach 0 level Managerial implication: helps the firm to have an effective control over inventories, help to ensure the supply of required quantity of inventories at the required time.