Introduction to Financial Models for Management and Planning

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1 CHAPMAN &HALL/CRC FINANCE SERIES Introduction to Financial Models for Management and Planning James R. Morris University of Colorado, Denver U. S. A. John P. Daley University of Colorado, Denver U. S. A. Ltfi\ CRC Press v' J Taylor & Francis Group Boca Raton London New York CRC Press is an imprint of the Taylor & Francis Group, an informa business A CHAPMAN St HALL BOOK

2 Contents Preface Authors XXI xxix CHAPTER 1 An Overview of Financial and Modeling Planning 1.1 WHAT IS PLANNING? WHAT IS FINANCIAL PLANNING? THE INPUT TO FINANCIAL PLANNING The Goals of Financial Decisions The Decision Alternatives The Links between Decisions and Goals Resources and Constraints Company-Specific Resources and Constraints Industry-Specific Constraints Constraints Imposed by the Economy 12 1 vn

3 viii Contents Constraints Imposed by the Legal and Political Environment The Planning Horizon and the Amount of Detail The Length of the Planning Horizon The Amount of Detail INGREDIENTS OF A FINANCIAL MODEL What Is a Model? What Does a Model Do? HOW TO DEVELOP THE MODEL? The Decision Problem What Is the Problem? What Questions Must Be Answered? What Is the Time Horizon of the Problem? How Important Is the Problem? The Output What Kind of Information Is Needed? How Will the Information Be Evaluated? What Kind of Detail Is Necessary? Who Will Use the Information? The Structural Input What Is the Goal? 24 \ What Are the Decision Alternatives? What Are the Linkages between the Decisions and the Goal? What Are the Constraints? What Is the Planning Horizon? The Data Input The Current State of the System Relations between Variables Forecasts of Future Conditions TYPES OF MODELS Simulation Optimization 32

4 Contents ix 1.7 WHAT DO WE GET OUT OF THE MODELING PROCESS? Explicit Benefits Implicit Benefits SUMMARY 35 PART I Tools for Financial Planning and Modeling: Financial Analysis 37 CHAPTER 2 Tools for Financial Planning I: Financial Analysis INTRODUCTION FINANCIAL RATIO ANALYSIS Example: The Odd & Rich Corporation DuPont Analysis Asset Utilization Operating Cycle The Equity Multiplier and Financial Leverage BREAK-EVEN ANALYSIS Fixed and Variable Costs ANALYSIS OF OPERATING AND FINANCIAL LEVERAGE Degree of Operating Leverage Degree of Financial Leverage Degree of Combined Leverage CONCLUSION 68 APPENDIX A: USING NAMES IN THE EXCEL SPREADSHEET 72 APPENDIX B: CONSTRUCTING A DATA TABLE 75 CHAPTER 3 The Tools for Financial Planning II: Growth and Cash Flows PROJECTING PRO FORMA FINANCIAL STATEMENTS GROWTH AND THE NEED FOR FINANCING Required External Financing Sustainable Growth 92

5 x Contents 3.3 CASH FLOW Cash Flow from Operations Cash Flow from Investing Cash Flows from Financing Equity Cash Flow Cash Flow to Invested Capital CASH RECEIPTS AND DISBURSEMENTS Example: The Mogul Corporation CONCLUSION 119 PART II Tools for Financial Planning and Modeling: Simulation 127 CHAPTER 4 Financial Statement Simulation 1_ INTRODUCTION THE ACCOUNTING MODULE Equations of the Module The Income Generation Module The Investment Module The Financing Module EQUILIBRIUM IN THE SIMULATION MODEL BUILDING A LONG-RANGETLANNING MODEL Model of O&R Corp Testing the Model Tracking Performance Valuation The Valuation Module Evaluation and Sensitivity Analysis CONCLUSION 163 CHAPTER 5 Monte Carlo Simulation INTRODUCTION MONTE CARLO SIMULATION 173

6 Contents xi 5.3 THE EBITDA MODEL AND RISK MONTE CARLO SOFTWARE: RISK Steps for Running an Initial Simulation Putting the Output into the Spreadsheet Correlating the Variables Model Results with Correlated Variables USING MONTE CARLO SIMULATION FOR CAPITAL INVESTMENT DECISIONS Example: Capital Investment for Placidia Corporation Conventional NPV Analysis Monte Carlo Simulation of the Placidia Project Example: Success and Failure of Research and Development Conventional Analysis of the NPV of Project Risk in the R&D Program Monte Carlo Simulation of Project SUMMARY- 207 PART 111 Introduction to Forecasting Methods 217 CHAPTER 6 Forecasting I: Time Trend Extrapolation AN INTRODUCTION TO FORECASTING Qualitative versus Quantitative Forecasts STEPS FOR DEVELOPING A FORECASTING MODEL TIME TREND EXTRAPOLATION Estimation Period versus Hold-Out Period Time Trend Extrapolation Using Linear Regression The Constant Change Model The Compound Growth Model Assessing Model Validity and Accuracy Evaluating Model Validity 230

7 xii Contents 6.4 EVALUATING FORECAST ACCURACY Diagnostic Measures Mean Error Mean Absolute Deviation Root Mean Square Error Residual Standard Error Combining the Estimation Period and the Hold-Out Period The Last Step: Making the Forecast Assessing Forecast Accuracy: Confidence Intervals The Standard Error of the Forecast The Critical Statistic Problems with the Forecasting Model Assumptions of the Regression Model SUMMARY 247 CHAPTER 7 Forecasting II: Econometric Forecasting DEVELOPING A STRUCTURAL ECONOMETRIC MODEL Example: Speckled Band, Inc The Economic and Industry Context Confidence Interval of the Forecast SUMMARY 264 CHAPTER 8 Forecasting III: Smoothing Data for Forecasts INTRODUCTION MOVING AVERAGE EXPONENTIAL SMOOTHING EVALUATING THE MODEL Making the Forecast SEASONALLY AND SEASONAL DECOMPOSITION Sources of Variation in Data Seasonal Adjustment Factors Estimating the Seasonal Adjustment Factors 290

8 Contents xiii Removing Seasonality Forecasting Sales Review of Seasonal Adjustment TIME SERIES MODELS A Description of Time Series Models Two Processes: AR and MA Autoregressive Processes Moving Average Processes ARMA and ARIMA Processes An Overview of the Box-Jenkins Method SUMMARY 311 PART IV A Closer Look at the Details of a Financial Model 319 CHAPTER 9 Modeling Value AGGREGATE EQUITY VALUE DIVIDENDS VERSUS EQUITY CASH FLOW Value for a Non-Dividend-Paying Firm TERMINAL VALUE The Constant Growth Model Components of the Terminal Growth Rate Other Models of Terminal Value THE DISCOUNT RATE: LEVERAGE, CIRCULARITY, AND CONVERGENCE Cost of Equity with a Changing Capital Structure VALUE PER SHARE AND ISSUING NEW EQUITY Example: Mythic Corporation Share Issue and Dilution in the Empruntay Model 348

9 xiv Contents CHAPTER 10 Modeling Long-Term Assets FIXED ASSETS IN A LONG-RUN PLANNING MODEL 10.2 DIRECT INVESTMENT EVALUATION Investment Evaluation The WACC Method Cost of Investment Discount Rate Cash Flow to Invested Capital The Equity Method Working Capital 10.3 EXAMPLE: EVALUATING AN INVESTMENT FOR STILIKO PLASTICS The Details of the Investment The Opportunity The Objective Financing The Planning Horizon The Constraints Project Investment Depreciation Terminal (Salvage) Value Constructing the Spreadsheet Model Data Input Data Processing Sheet Initial Investment Accounting Sections Costs of Capital Section Evaluation Sheet The Invested Capital Method Equity Method Evaluating the Investment's Impact on the Firm 389

10 Contents xv 10.4 MODELING MERGERS AND ACQUISITIONS Overview Modeling the Merger and Acquisition Problem The Merger Synergies Monte Carlo Simulation Cost of Goods Sold Selling, General, and Administrative Costs Research and Development Receivables and Inventory Gross Plant and Equipment Accounts Payable Growth Rates Integration Costs Output SUMMARY 411 CHAPTER 11 Debt Financing 4T\_ 11.1 DEBT IN THE LONG-TERM PLANNING MODEL Constraining the Debt Ratios Example: A Borrowing Sector for O&R Analyzing the Financing Decision USING MONTE CARLO SIMULATION TO FIND THE OPTIMAL CAPITAL STRUCTURE Default Risk, Tax Savings, and Bankruptcy Costs Default Risk Tax Savings Bankruptcy Costs Net Benefits from Debt The Monte Carlo Model Simulating the Risk of Default and Bankruptcy Simulating Default Risk 443

11 xvi, Contents Balancing Taxes and Bankruptcy Costs Simulating the Net Benefit of Debt ADDITIONAL DEBT MODELING CONCEPTS Duration Duration as Average Life of Cash Flows Duration as Interest Rate Sensitivity Duration and Immunization Swaps Example: Swapping Plain Vanilla Stochastic Interest Rates SUMMARY 469 CHAPTER 12 Modeling Working Capital Accounts CASH J2.2 MARKETABLE SECURITIES Example: Managing Securities for the Mogul Corporation 12.3 MODELING RECEIVABLES AND CREDIT 12.4 INVENTORIES 12.5 SPONTANEOUS FINANCING 1'2.6 SUMMARY PART V Modeling Security Prices and Investment Portfolios 509 CHAPTER 13 Modeling Security Prices THE BINOMIAL MODEL OF STOCK PRICE MOVEMENT STOCK PRICES AS A RANDOM WALK IN CONTINUOUS TIME BINOMIAL APPROXIMATION OF THE CONTINUOUS PRICE PROCESS 520

12 Contents xvii 13.4 RETURNS FOR A PORTFOLIO OF SECURITIES Correlating the Returns Running the Model SUMMARY 533 CHAPTER 14 Constructing Optimal Security Portfolios INTRODUCTION THE MEAN-VARIANCE PROBLEM FOR TWO ASSETS A LITTLE LINEAR ALGEBRA Naming the Arrays THE EFFICIENT FRONTIER WITH MULTIPLE ASSETS EXTENSIONS OF MODERN PORTFOLIO THEORY The Tangency Portfolio Extension of the Model to the CAPM Counterintuitive Recommendations VALUE-AT-RISK Computational Method Historical Simulation Monte Carlo Simulation Simulated Portfolios Discussion of Results SUMMARY 575 CHAPTER 15 Options INTRODUCTION Introducing Calls and Puts PAYOFFS FROM OPTIONS Buying Options Writing Options Options as a Leveraged Investment in the Stock Option Combinations Mixing Options with the Stock and a Bond 590

13 xviii Contents 15.3 OPTION PRICING MODELS Binomial Option Pricing Option Pricing by Replicating the Payoffs An Arbitrage Transaction The Cox, Ross, and Rubinstein Binomial Option Formula Put Value Put-Call Parity Multi-Step Binomial Option Models Two Periods Modeling Option Prices with the Binomial Approximation of Continuous Prices OPTION PRICING WITH CONTINUOUS STOCK RETURNS: THE BLACK-SCHOLES MODEL SUMMARY 618 PART VI Optimization Models 621 CHAPTER 16 Optimization Models for Financial Planning INTRODUCTION TO OPTIMIZATION CONSTRAINED OPTIMIZATION Linear Programming Using Solver to Find a Solution Example: Investment Decisions on a Limited Budget Decision Variables Objective Function Constraints Using Excel and Solver for the Gartner Problem ELABORATIONS ON THE BASIC MODEL Mutually Exclusive Projects Contingent Protects

14 Contents XIX Lending and Borrowing Lending Borrowing A BORROWING IN THE LP PLANNING MODEL Risk Constraint SUMMARY 660 CHAPTER 17 Planning and Managing Working Capital with LP OPTIMIZING WORKING CAPITAL DECISIONS 17.2 WORKING CAPITAL DECISIONS FOR THE STILIKO COMPANY Marketable Securities Borrowing Cash Balance Time Objective Decision Variables Security Purchases Borrowing Cash Balance Constraints Objective Function Constraints 17.3 ELABORATIONS AND EXTENSIONS Debt Repayment Objective Constraints Repayment Borrowing Limit Cash Flow Constraint 17.3 A Another Source of Debt Financing: Accounts Payable (AP) Decision Variables

15 xx Contents Objective Constraints Selling Securities Decision Variables Constraints Objective Function SUMMARY 689 References 691 Index 701

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