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# What Is A Financial Model

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### What Is A Financial Model

1. 1. What is a Financial Model A financial model is a (quantitative, accounting or hybrid of the two) logic chain that is designed to forecast possible future outcomes based on data inputs
2. 2. Basis of Modeling in Engineering and Science. •Newton invented calculus to model his physics theories •The Wright Brothers used models to develop and select airfoil designs •Cad-Cam software is an aggregation of many models used to design products, tools, furniture….
3. 3. Several Types of Financial Models •Econometric Models and Quantitative Models •Leading Economic Indicators •Black Scholes •Industry Models •Regression Models •Earnings Models (Often hybrid b/t accounting and Quant) •Revenue Models •Valuation models •Cost and Breakeven Analysis
4. 4. Example of a Model Regression Model(hypothetical): •A reit analyst observes a statistical correlation b/t housing starts and the Population of the US •The model looks like this: #New Homes = 780,000+.004(POP) •If the US population estimate is 280mm then the analyst may forecast #New Homes of approx. 1.9mm 780,000 Problems Benefits H o Assumptions Better than guessing m Other variables Forecasting 1,900,000 e Change Objectivity s Integrity 280,000,000 Population
5. 5. Good analysts should spend most of their time developing and interpreting models
6. 6. Valuation Analysis and Models Two Schools of Thought (not an oxymoron) Top Down Bottom Up
7. 7. Top Down The CFA institute recommends that most analysts focus on Top Down Analysis because; the correlation between corporate earnings and the economy is strong, earnings and investment performance is strong and the correlation between stock returns and industry returns is also strong.
8. 8. Case Study of a Top Down Earnings Model Model Step 1 Step 2 Step 3 The Analyst Collects The Analyst Develops Analyst plugs revenue, cost Income Statement and share estimates into Economic Data Model accounting model and Financial Data forecasts EPS Industry Data Based on observations, Customer Data experience and Estimates generated and Product Data assumptions compared with real world Other Data outcomes New Earnings Data
9. 9. BNHN Model Assumptions: Recent Share Price: \$14.00 As of November 18, 2005 Equity Purchase Price per Share: 17.00 21.4% Premium to recent share price Shares Outstanding: 9,795.9 Based on most recent 10-Q, includes effect of outstanding options Market Value (Recent) \$137,142.2 Price times shares Market Value (Offer) 166,529.8 Price times shares Transaction Value (Offer) 180,463.3 Market Value + Debt + Trans. Costs - Cash Trans. Value / LTM EBITDA 7.9x Tax Rate: 33.5% Approximate tax rate in 4Q 2004 Interest Rate: 7.0% Assumption \$ % Sources: Total Debt: \$125,000 68.0% Assumes all traditional and institutional bank debt New Equity: 50,422 27.4% Assumes additional equity to keep Debt/EBITDA at closing at approx. 5x Rolled Equity: 8,326 4.5% Assumes insiders with 5% of common stock roll into LBO Total Sources: \$183,748 Uses: Summary of LBO Returns: IRR Refinance Debt: \$11,706 Holding Period \$17/Sh \$18/Sh \$19/Sh Purchase Equity: 166,530 3 Year 24.9% 18.4% 13.2% Transaction Expenses 5,512 4 Year 22.9% 18.1% 14.1% Total Uses: \$183,748 5 Year 20.7% 16.9% 13.7% Income Statement 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Revenues \$207,252.0 \$217,614.6 \$228,495.3 \$239,920.1 \$247,117.7 \$254,531.2 \$262,167.2 \$270,032.2 \$278,133.1 \$286,477.1 Revenue Growth --- 5.0% 5.0% 5.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% EBITDA \$24,642.2 \$25,874.3 \$27,168.1 \$28,526.5 \$29,382.3 \$30,263.7 \$31,171.6 \$32,106.8 \$33,070.0 \$34,062.1 EBITDA Margin 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% 11.9% Depreciation 9,041.0 8,992.7 8,948.7 8,908.6 8,872.2 8,838.9 8,808.7 8,781.1 8,756.0 8,733.1 EBIT \$15,601.2 \$16,881.6 \$18,219.3 \$19,617.8 \$20,510.1 \$21,424.8 \$22,363.0 \$23,325.7 \$24,314.0 \$25,328.9 Pro Forma Interest Expense 8,574.0 8,177.3 7,696.1 7,131.9 6,497.8 5,801.4 5,032.0 4,184.9 3,254.9 2,237.0 Pro Forma Interest Income 98.6 98.6 98.6 98.6 98.6 98.6 98.6 98.6 98.6 98.6 Pre-Tax Income 7,125.8 8,802.9 10,621.8 12,584.4 14,110.9 15,721.9 17,429.5 19,239.4 21,157.6 23,190.5 Income Taxes 2,388.3 2,950.4 3,560.0 4,217.8 4,729.4 5,269.3 5,841.6 6,448.2 7,091.1 7,772.5 Net Income \$4,737.5 \$5,852.5 \$7,061.8 \$8,366.7 \$9,381.5 \$10,452.6 \$11,587.9 \$12,791.1 \$14,066.5 \$15,418.0 Calculation of Free Cash Flow Net Income \$4,737.5 \$5,852.5 \$7,061.8 \$8,366.7 \$9,381.5 \$10,452.6 \$11,587.9 \$12,791.1 \$14,066.5 \$15,418.0 Working Capital Requirements (250.0) (39.5) (67.7) (98.7) (311.2) (338.4) (367.0) (397.0) (428.5) (461.5) Depreciation 9,041.0 8,992.7 8,948.7 8,908.6 8,872.2 8,838.9 8,808.7 8,781.1 8,756.0 8,733.1 Maintenance Capex (8,500.0) (8,500.0) (8,500.0) (8,500.0) (8,500.0) (8,500.0) (8,500.0) (8,500.0) (8,500.0) (8,500.0) Free Cash Flow \$5,028.5 \$6,305.8 \$7,442.8 \$8,676.6 \$9,442.5 \$10,453.1 \$11,529.5 \$12,675.2 \$13,894.0 \$15,189.7 Summary Balance Sheet Items Cash 3,285.0 3,285.0 3,285.0 3,285.0 3,285.0 3,285.0 3,285.0 3,285.0 3,285.0 3,285.0 Current Assets 12,597.0 13,226.9 13,888.2 14,582.6 15,020.1 15,470.7 15,934.8 16,412.8 16,905.2 17,412.4 Days of Sales 22.2 22.2 22.2 22.2 22.2 22.2 22.2 22.2 22.2 22.2 Current Liabilities 22,314.0 22,904.4 23,498.0 24,093.8 24,220.0 24,332.2 24,429.3 24,510.3 24,574.2 24,619.9 Days of CoGS 44.6 43.6 42.6 41.6 40.6 39.6 38.6 37.6 36.6 35.6 Debt 125,000.0 119,971.5 113,665.7 106,222.9 97,546.3 88,103.8 77,650.7 66,121.2 53,446.0 39,552.0 Equity 58,748.3 64,600.8 71,662.6 80,029.3 89,410.8 99,863.4 111,451.3 124,242.4 138,308.8 153,726.8 PP&E Schedule Beginning Assets \$101,258.0 \$100,717.0 \$100,224.3 \$99,775.6 \$99,367.0 \$98,994.8 \$98,655.9 \$98,347.2 \$98,066.1 \$97,810.1 Depreciation (9,041.0) (8,992.7) (8,948.7) (8,908.6) (8,872.2) (8,838.9) (8,808.7) (8,781.1) (8,756.0) (8,733.1) Additions 8,500.0 8,500.0 8,500.0 8,500.0 8,500.0 8,500.0 8,500.0 8,500.0 8,500.0 8,500.0 Ending Assets 100,717.0 100,224.3 99,775.6 99,367.0 98,994.8 98,655.9 98,347.2 98,066.1 97,810.1 97,577.0 Beg. Assets / Depr. -11.2x -11.2x -11.2x -11.2x -11.2x -11.2x -11.2x -11.2x -11.2x -11.2x