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
Contents Preface Authors XXI xxix CHAPTER 1 An Overview of Financial and Modeling Planning 1.1 WHAT IS PLANNING? 2 1.2 WHAT IS FINANCIAL PLANNING? 4 1.3 THE INPUT TO FINANCIAL PLANNING 5 1.3.1 The Goals of Financial Decisions 7 1.3.2 The Decision Alternatives 7 1.3.3 The Links between Decisions and Goals 8 1.3.4 Resources and Constraints 9 1.3.4.1 Company-Specific Resources and Constraints 10 1.3.4.2 Industry-Specific Constraints 11 1.3.4.3 Constraints Imposed by the Economy 12 1 vn
viii Contents 1.3.4.4 Constraints Imposed by the Legal and Political Environment 13 1.3.5 The Planning Horizon and the Amount of Detail 13 1.3.5.1 The Length of the Planning Horizon 13 1.3.5.2 The Amount of Detail 14 1.4 INGREDIENTS OF A FINANCIAL MODEL 16 1.4.1 What Is a Model? 16 1.4.2 What Does a Model Do? 20 1.5 HOW TO DEVELOP THE MODEL? 21 1.5.1 The Decision Problem 21 1.5.1.1 What Is the Problem? 21 1.5.1.2 What Questions Must Be Answered? 21 1.5.1.3 What Is the Time Horizon of the Problem? 22 1.5.1.4 How Important Is the Problem? 22 1.5.2 The Output 22 1.5.2.1 What Kind of Information Is Needed? 22 1.5.2.2 How Will the Information Be Evaluated? 23 1.5.2.3 What Kind of Detail Is Necessary? 23 1.5.2.4 Who Will Use the Information? 23 1.5.3 The Structural Input 24 1.5.3.1 What Is the Goal? 24 \ 1.5.3.2 What Are the Decision Alternatives? 25 1.5.3.3 What Are the Linkages between the Decisions and the Goal? 25 1.5.3.4 What Are the Constraints? 25 1.5.3.5 What Is the Planning Horizon? 27 1.5.4 The Data Input 28 1.5.4.1 The Current State of the System 28 1.5.4.2 Relations between Variables 29 1.5.4.3 Forecasts of Future Conditions 29 1.6 TYPES OF MODELS 30 1.6.1 Simulation 30 1.6.2 Optimization 32
Contents ix 1.7 WHAT DO WE GET OUT OF THE MODELING PROCESS? 33 1.7.1 Explicit Benefits 34 1.7.2 Implicit Benefits 34 1.8 SUMMARY 35 PART I Tools for Financial Planning and Modeling: Financial Analysis 37 CHAPTER 2 Tools for Financial Planning I: Financial Analysis 39 2.1 INTRODUCTION 39 2.2 FINANCIAL RATIO ANALYSIS 40 2.2.1 Example: The Odd & Rich Corporation 41 2.2.2 DuPont Analysis 52 2.2.2.1 Asset Utilization 54 2.2.2.2 Operating Cycle 55 2.2.2.3 The Equity Multiplier and Financial Leverage 56 23 BREAK-EVEN ANALYSIS 60 2.3.1 Fixed and Variable Costs 60 2.4 ANALYSIS OF OPERATING AND FINANCIAL LEVERAGE 64 2.4.1 Degree of Operating Leverage 65 2.4.2 Degree of Financial Leverage 66 2.4.3 Degree of Combined Leverage 67 2.5 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 79 3.1 PROJECTING PRO FORMA FINANCIAL STATEMENTS 80 3.2 GROWTH AND THE NEED FOR FINANCING 88 3.2.1 Required External Financing 89 3.2.2 Sustainable Growth 92
x Contents 3.3 CASH FLOW 96 3.3.1 Cash Flow from Operations 99 3.3.2 Cash Flow from Investing 102 3.3.3 Cash Flows from Financing 104 3.3.3.1 Equity Cash Flow 105 3.3.3.2 Cash Flow to Invested Capital 107 3.4 CASH RECEIPTS AND DISBURSEMENTS 109 3.4.1 Example: The Mogul Corporation 110 3.5 CONCLUSION 119 PART II Tools for Financial Planning and Modeling: Simulation 127 CHAPTER 4 Financial Statement Simulation 1_29 4.1 INTRODUCTION 129 4.2 THE ACCOUNTING MODULE 131 4.2.1 Equations of the Module 131 4.2.2 The Income Generation Module 138 4.2.3 The Investment Module 139 4.2.4 The Financing Module 140 4.3 EQUILIBRIUM IN THE SIMULATION MODEL 141 4.4 BUILDING A LONG-RANGETLANNING MODEL 145 4.4.1 Model of O&R Corp. 145 4.4.2 Testing the Model 155 4.4.3 Tracking Performance 157 4.4.4 Valuation 159 4.4.4.1 The Valuation Module 159 4.4.4.2 Evaluation and Sensitivity Analysis 162 4.5 CONCLUSION 163 CHAPTER 5 Monte Carlo Simulation 171 5.1 INTRODUCTION 171 5.2 MONTE CARLO SIMULATION 173
Contents xi 5.3 THE EBITDA MODEL AND RISK 177 5.4 MONTE CARLO SOFTWARE: RISK 180 5.4.1 Steps for Running an Initial Simulation 184 5.4.2 Putting the Output into the Spreadsheet 186 5.4.3 Correlating the Variables 189 5.4.3.1 Model Results with Correlated Variables 192 5.5 USING MONTE CARLO SIMULATION FOR CAPITAL INVESTMENT DECISIONS 193 5.5.1 Example: Capital Investment for Placidia Corporation 193 5.5.1.1 Conventional NPV Analysis 194 5.5.1.2 Monte Carlo Simulation of the Placidia Project 195 5.5.2 Example: Success and Failure of Research and Development 201 5.5.2.1 Conventional Analysis of the NPV of Project 202 5.5.2.2 Risk in the R&D Program 202 5.5.2.3 Monte Carlo Simulation of Project 204 5.6 SUMMARY- 207 PART 111 Introduction to Forecasting Methods 217 CHAPTER 6 Forecasting I: Time Trend Extrapolation 219 6.1 AN INTRODUCTION TO FORECASTING 219 6.1.1 Qualitative versus Quantitative Forecasts 220 6.2 STEPS FOR DEVELOPING A FORECASTING MODEL 220 6.3 TIME TREND EXTRAPOLATION 221 6.3.1 Estimation Period versus Hold-Out Period 224 6.3.2 Time Trend Extrapolation Using Linear Regression 225 6.3.2.1 The Constant Change Model 225 6.3.2.2 The Compound Growth Model 228 6.3.3 Assessing Model Validity and Accuracy 230 6.3.3.1 Evaluating Model Validity 230
xii Contents 6.4 EVALUATING FORECAST ACCURACY 235 6.4.1 Diagnostic Measures 235 6.4.1.1 Mean Error 236 6.4.1.2 Mean Absolute Deviation 236 6.4.1.3 Root Mean Square Error 237 6.4.1.4 Residual Standard Error 237 6.4.2 Combining the Estimation Period and the Hold-Out Period 238 6.4.3 The Last Step: Making the Forecast 239 6.4.4 Assessing Forecast Accuracy: Confidence Intervals 240 6.4.5 The Standard Error of the Forecast 241 6.4.5.1 The Critical Statistic 243 6.4.6 Problems with the Forecasting Model 245 6.4.6.1 Assumptions of the Regression Model 245 6.5 SUMMARY 247 CHAPTER 7 Forecasting II: Econometric Forecasting 253 7.1 DEVELOPING A STRUCTURAL ECONOMETRIC MODEL 253 7.1.1 Example: Speckled Band, Inc. 254 7.1.1.1 The Economic and Industry Context 254 7.1.2 Confidence Interval of the Forecast 263 7.2 SUMMARY 264 CHAPTER 8 Forecasting III: Smoothing Data for Forecasts 273 8.1 INTRODUCTION 273 8.2 MOVING AVERAGE 274 8.3 EXPONENTIAL SMOOTHING 278 8.4 EVALUATING THE MODEL 283 8.4.1 Making the Forecast 285 8.5 SEASONALLY AND SEASONAL DECOMPOSITION 285 8.5.1 Sources of Variation in Data 286 8.5.2 Seasonal Adjustment Factors 287 8.5.2.1 Estimating the Seasonal Adjustment Factors 290
Contents xiii 8.5.3 Removing Seasonality 292 8.5.4 Forecasting Sales 295 8.5.5 Review of Seasonal Adjustment 298 8.6 TIME SERIES MODELS 299 8.6.1 A Description of Time Series Models 301 8.6.2 Two Processes: AR and MA 302 8.6.2.1 Autoregressive Processes 302 8.6.2.2 Moving Average Processes 308 8.6.3 ARMA and ARIMA Processes 309 8.6.4 An Overview of the Box-Jenkins Method 309 8.7 SUMMARY 311 PART IV A Closer Look at the Details of a Financial Model 319 CHAPTER 9 Modeling Value 321 9.1 AGGREGATE EQUITY VALUE 321 9.2 DIVIDENDS VERSUS EQUITY CASH FLOW 322 9.2.1 Value for a Non-Dividend-Paying Firm 326 9.3 TERMINAL VALUE 327 9.3.1 The Constant Growth Model 327 9.3.1.1 Components of the Terminal Growth Rate 328 9.3.2 Other Models of Terminal Value 330 9.4 THE DISCOUNT RATE: LEVERAGE, CIRCULARITY, AND CONVERGENCE 332 9.4.1 Cost of Equity with a Changing Capital Structure 336 9.5 VALUE PER SHARE AND ISSUING NEW EQUITY 342 9.5.1 Example: Mythic Corporation 344 9.5.2 Share Issue and Dilution in the Empruntay Model 348
xiv Contents CHAPTER 10 Modeling Long-Term Assets 361 10.1 FIXED ASSETS IN A LONG-RUN PLANNING MODEL 10.2 DIRECT INVESTMENT EVALUATION 10.2.1 Investment Evaluation 10.2.2 The WACC Method 10.2.2.1 Cost of Investment 10.2.2.2 Discount Rate 10.2.2.3 Cash Flow to Invested Capital 10.2.3 The Equity Method 10.2.4 Working Capital 10.3 EXAMPLE: EVALUATING AN INVESTMENT FOR STILIKO PLASTICS 10.3.1 The Details of the Investment 10.3.1.1 The Opportunity 10.3.1.2 The Objective 10.3.1.3 Financing 10.3.1.4 The Planning Horizon 10.3.1.5 The Constraints 10.3.1.6 Project Investment 10.3.1.7 Depreciation 10.3.1.8 Terminal (Salvage) Value 10.3.2 Constructing the Spreadsheet Model 10.3.2.1 Data Input 10.3.2.2 Data Processing Sheet 10.3.2.3 Initial Investment 10.3.2.4 Accounting Sections 10.3.2.5 Costs of Capital Section 10.3.2.6 Evaluation Sheet 10.3.2.7 The Invested Capital Method 10.3.2.8 Equity Method 362 365 365 367 367 367 368 369 372 372 372 372 373 373 373 374 374 375 375 375 376 378 379 380 384 384 384 387 10.3.3 Evaluating the Investment's Impact on the Firm 389
Contents xv 10.4 MODELING MERGERS AND ACQUISITIONS 394 10.4.1 Overview 394 10.4.2 Modeling the Merger and Acquisition Problem 395 10.4.2.1 The Merger 396 10.4.2.2 Synergies 398 10.4.3 Monte Carlo Simulation 405 10.4.3.1 Cost of Goods Sold 406 10.4.3.2 Selling, General, and Administrative Costs 406 10.4.3.3 Research and Development 407 10.4.3.4 Receivables and Inventory 407 10.4.3.5 Gross Plant and Equipment 407 10.4.3.6 Accounts Payable 407 10.4.3.7 Growth Rates 408 10.4.3.8 Integration Costs 408 10.4.3.9 Output 408 10.5 SUMMARY 411 CHAPTER 11 Debt Financing 4T\_ 11.1 DEBT IN THE LONG-TERM PLANNING MODEL 421 11.1.1 Constraining the Debt Ratios 423 11.1.2 Example: A Borrowing Sector for O&R 426 11.1.3 Analyzing the Financing Decision 435 11.2 USING MONTE CARLO SIMULATION TO FIND THE OPTIMAL CAPITAL STRUCTURE 435 11.2.1 Default Risk, Tax Savings, and Bankruptcy Costs 436 11.2.1.1 Default Risk 436 11.2.1.2 Tax Savings 437 11.2.1.3 Bankruptcy Costs 437 11.2.1.4 Net Benefits from Debt 438 11.2.2 The Monte Carlo Model 438 11.2.2.1 Simulating the Risk of Default and Bankruptcy 438 11.2.2.2 Simulating Default Risk 443
xvi, Contents 11.2.2.3 Balancing Taxes and Bankruptcy Costs 446 11.2.2.4 Simulating the Net Benefit of Debt 448 11.3 ADDITIONAL DEBT MODELING CONCEPTS 453 11.3.1 Duration 453 11.3.1.1 Duration as Average Life of Cash Flows 453 11.3.1.2 Duration as Interest Rate Sensitivity 456 11.3.1.3 Duration and Immunization 458 11.3.2 Swaps 459 11.3.2.1 Example: Swapping Plain Vanilla 460 11.3.2.2 Stochastic Interest Rates 464 11.4 SUMMARY 469 CHAPTER 12 Modeling Working Capital Accounts 477 12.1 CASH J2.2 MARKETABLE SECURITIES 12.2.1 Example: Managing Securities for the Mogul Corporation 12.3 MODELING RECEIVABLES AND CREDIT 12.4 INVENTORIES 12.5 SPONTANEOUS FINANCING 1'2.6 SUMMARY 478 483 486 496 499 502 504 PART V Modeling Security Prices and Investment Portfolios 509 CHAPTER 13 Modeling Security Prices 511 13.1 THE BINOMIAL MODEL OF STOCK PRICE MOVEMENT 511 13.2 STOCK PRICES AS A RANDOM WALK IN CONTINUOUS TIME 516 13.3 BINOMIAL APPROXIMATION OF THE CONTINUOUS PRICE PROCESS 520
Contents xvii 13.4 RETURNS FOR A PORTFOLIO OF SECURITIES 523 13.4.1 Correlating the Returns 526 13.4.2 Running the Model 530 13.5 SUMMARY 533 CHAPTER 14 Constructing Optimal Security Portfolios 535 14.1 INTRODUCTION 535 14.2 THE MEAN-VARIANCE PROBLEM FOR TWO ASSETS 536 14.3 A LITTLE LINEAR ALGEBRA 543 14.3.1 Naming the Arrays 549 14.4 THE EFFICIENT FRONTIER WITH MULTIPLE ASSETS 550 14.5 EXTENSIONS OF MODERN PORTFOLIO THEORY 556 14.5.1 The Tangency Portfolio 556 14.5.1.1 Extension of the Model to the CAPM 558 14.5.2 Counterintuitive Recommendations 559 14.6 VALUE-AT-RISK 564 14.6.1 Computational Method 565 14.6.2 Historical Simulation 567 14.6.3 Monte Carlo Simulation 569 14.6.3.1 Simulated Portfolios 569 14.6.4 Discussion of Results 574 14.7 SUMMARY 575 CHAPTER 15 Options 581 15.1 INTRODUCTION 581 15.1.1 Introducing Calls and Puts 582 15.2 PAYOFFS FROM OPTIONS 583 15.2.1 Buying Options 583 15.2.2 Writing Options 586 15.2.3 Options as a Leveraged Investment in the Stock 587 15.2.4 Option Combinations 587 15.2.5 Mixing Options with the Stock and a Bond 590
xviii Contents 15.3 OPTION PRICING MODELS 593 15.3.1 Binomial Option Pricing 593 15.3.1.1 Option Pricing by Replicating the Payoffs 595 15.3.1.2 An Arbitrage Transaction 597 15.3.1.3 The Cox, Ross, and Rubinstein Binomial Option Formula 601 15.3.1.4 Put Value 602 15.3.2 Put-Call Parity 602 15.3.3 Multi-Step Binomial Option Models 607 15.3.3.1 Two Periods 607 15.3.3.2 Modeling Option Prices with the Binomial Approximation of Continuous Prices 609 15.4 OPTION PRICING WITH CONTINUOUS STOCK RETURNS: THE BLACK-SCHOLES MODEL 614 15.5 SUMMARY 618 PART VI Optimization Models 621 CHAPTER 16 Optimization Models for Financial Planning 623 16.1 INTRODUCTION TO OPTIMIZATION 623 16.2 16.3 CONSTRAINED OPTIMIZATION 16.2.1 Linear Programming 16.2.2 Using Solver to Find a Solution 16.2.3 Example: Investment Decisions on a Limited Budget 16.2.3.1 Decision Variables 16.2.3.2 Objective Function 16.2.3.3 Constraints 16.2.4 Using Excel and Solver for the Gartner Problem ELABORATIONS ON THE BASIC MODEL 16.3.1 Mutually Exclusive Projects 16.3.2 Contingent Protects 626 627 632 636 638 638 639 643 646 647 647
Contents XIX 16.3.3 Lending and Borrowing 648 16.3.3.1 Lending 649 16.3.3.2 Borrowing 650 16A BORROWING IN THE LP PLANNING MODEL 654 16.4.1 Risk Constraint 658 16.5 SUMMARY 660 CHAPTER 17 Planning and Managing Working Capital with LP 667 17.1 OPTIMIZING WORKING CAPITAL DECISIONS 17.2 WORKING CAPITAL DECISIONS FOR THE STILIKO COMPANY 17.2.1 Marketable Securities 17.2.2 Borrowing 17.2.3 Cash Balance 17.2.4 Time 17.2.5 Objective 17.2.6 Decision Variables 17.2.6.1 Security Purchases 17.2.6.2 Borrowing 17.2.6.3 Cash Balance 17.2.7 Constraints 17.2.8 Objective Function 17.2.9 Constraints 17.3 ELABORATIONS AND EXTENSIONS 17.3.1 Debt Repayment 17.3.2 Objective 17.3.3 Constraints 17.3.3.1 Repayment 17.3.3.2 Borrowing Limit 17.3.3.3 Cash Flow Constraint 17.3 A Another Source of Debt Financing: Accounts Payable (AP) 17.3.5 Decision Variables 667 670 671 671 671 671 671 672 672 672 672 673 673 675 680 680 680 681 681 682 682 682 683
xx Contents 17.3.6 Objective 684 17.3.7 Constraints 685 17.3.8 Selling Securities 686 17.3.9 Decision Variables 686 17.3.10 Constraints 686 17.3.11 Objective Function 688 17.4 SUMMARY 689 References 691 Index 701