#StayAtHome Financial Modelling in the Mind

Tanous: I was an economics major at Georgetown. In my first economics class as a freshman, our professor, Dr. Gunther Ruff, asked the students why they were taking the course. I said, because I thought I might learn how to make money.

He said, “My dear fellow, I have a Ph.D. in economics, and if I knew how to make money, I wouldn’t be here.”

(quoted from an interview with Merton Miller — this is the second M in the MM Nobel Laureate — Peter J. Tanous, Investment Gurus, 1997, page 191)


Sometimes I got questions asking about when we are going to build a financial model, then what we need to do first.

You are given a blank spreadsheet (sounds familiar, right?) and then what is NEXT?

On your desk, you got heaps of the company’s financial statements, let’s say for the past 5 years.

The assignment from your boss is build the financial model to see how much is the estimated value of the Company.

You’re scratching your head and thinking hard and fast what is the first line to build and need to get prepared with sound answer in the case your boss is asking you WHY.

Ok, time is ticking away.

You are surfing the internet and find the website : www.futurumcorfinan.com with many articles inside that website but still you feel a bit anxious about what TO GET STARTED on your blank spreadsheet.

You sent email to Karnen, and he replied:

Please refer to the paper of 1958 and EBITDA (Earnings Before Interest Tax Depreciation and Amortization (or EBDAIT if we follow the sequence of those items shown in the Statement of Profit and Loss).

You stopped and can’t believe what you’re reading: what the h**ck the paper of 1958 is to do with the Financial Modelling? EBITDA, yeah,,, I heard that before and I know what’s is that…the earnings power of the company, taking out the financial structure of the company (you feel a bit puffed up).

Ok, then I am asking you, are you coming from Finance class?

and you answered, yes, I was coming from Finance class, but that’s probably 10-15 years ago. If I can’t remember the title of the finance book, then how come you expect me to remember the 1958 paper. You might be pulling my feet away!

Oke..oke…let’s me clarify that.

1958 is the year, when the two economists on Carnegie Tech’s Business School faculty, published their seminal and momentous paper: The Cost of Capital, Corporate Finance and the Theory of Investments (American Economic Review, June 1958, page 261-297). They are (i) Franco Modigliani, an Italia who after emigrating to the United States in 1939 studied with another giant economist, Jacob Marschak; and (ii) Merton Miller, a Ph.D from Johns Hopskins.

You should read this paper, I said, especially the title has mentioned “…theory…” word. I like it when the paper puts this “theory” word, which means, there is something beyond a mix of common sense, judgment, and tradition in finance world.

What comes up from that 1958 paper is the idea that it is super essential in any financial model that we should begin with EBITDA then evaluate what is needed to generate EBITDA before paying money to investors.

Two Giant Nobel Laureate, MM, with its 1958 paper is one of the most well-known paper in the world of Corporate Finance. They both could prove, that under given assumptions that are *):

  1. Securities issued by companies are traded in a perfect capital market, in which this is a frictionless market with no transaction costs and no barriers to the free flow of information.
  2. There are no taxes.
  3. Companies and individuals can borrow at the same rate of interest.
  4. There are no costs associated with the liquidation of a company,


This will in effect implicate that changing a company’s debt-equity ratio will change the way in which its NET OPERATING CASH FLOWS are divided between debtholders and shareholders, but it WILL NOT change the value of the Cash Flows.

That’s MM First Proposition or theorem, which is a law of CONSERVATION OF VALUE.  This law states that the value of an asset remains the same, regardless of how the net operating cash flows generated by the asset are divided between different classes of investors. The second MM proposition will talk about the NATURAL CONSERVATION OF RISK. So Value and Risk is like two sides of the same coin.

In another color to say, it is V_unlevered  = V_levered

Got it?

To give you a brief sense of HISTORY, the idea about the conservation of value could be traced back to 1938 book by another GREAT MINDs, John Burr Williams, in his pathbreaking book, The Theory of Investment Value. Another book with “Theory” word….

He said

If the investment value of an enterprise as a whole is by definition the present worth of all its future distributions to security holders, whether on interest or dividend account, then this value in no wise depends on what the company’s capitalization is. Clearly if a single individual or a single institutional investor owned all the bonds, stocks, and warrants issued by a corporation, it would not matter to this investor what the company’s capitalization was. Any earnings collected as interest could not be collected as dividends. To such an individual it would be perfectly obvious that total interest- and dividend-paying power was in now wise dependent on the kind of
securities issued to the company’s owner. Furthermore, no change in the investment value of the enterprise as a whole would result from a change in its capitalization. Bonds could be retired with stock issues, or two classes of junior securities (i.e., common stock and warrants) could be combined into one, without changing the investment value of the company as a whole. Such constancy of investment value is analogous to the indestructibility of matter or energy; it leads us to
speak of the Law of Conservation of Investment Value, just as physicists speak of the Law of the Conservation of Matter, or the Law of Conservation of Energy.

It is wonderful, isn’t it? 1938 paper and 1958 paper.


If you are accountant, then let me wear first my accountant’s head to brief this:

Thus proposition 1 of MM Theorem tells us that  Firm value is determined on the left-hand side of the balance sheet by real assets—not by the proportions of debt and equity
securities issued to buy the assets.

Ok, Ok, I got it, why we need to start with the EBITDA. But you said and kept saying about Cash Flows…. So how to get there?

Before, I am jumping to that, I need to make sure I could nail this EBITDA down to you.

It is super essential that you look into what components behind generating EBITDA. In other words, the KEY MAIN DRIVERS. EBITDA is something that you could see and even distribute it. You need to put your feet on the ground, and in the real world of corporate life, it is PRICES, DEMAND, CAPACITY and UTILIZATION (in the company and within the industry), OPERATING COST STRUCTURE (fixed cost and variable costs), etc. etc. Get your late-night homework done on analysing all of these. The whole purpose of breaking EBITDA to its main key drivers is to ensure that the project being analyzed is not just a black box, which what we are doing is just pickup whatever assumptions make sense, then build cash-flow forecasts, assess the risk, choose the discount rate and come up with the result (value, NPV, whatever it is). What could go wrong (it will be in reality) should be part of all this exercise!

I gather you are ready to move to the second stair, once you have a good grip on EBITDA, (while you pray) move your feet to CAPITAL EXPENDITURE. EBITDA will not be there unless you burn something. IT TAKES MONEY TO MAKE MONEY, another 2 MMs here. Hope you’ve never forgotten this. Capital expenditure, both new and maintenance, will be essential to keep the EBITDA churning as expected and forecasted.

Two last but certainly not least, is the (i) TAX…Taxes should be paid before any money is paid to investors. Don’t ever forget it. Benjamin Franklin said only certain in life: death and TAXES (Note: Did he ask the company to pay tax?), and .(ii) WORKING CAPITAL change to adjust the EBITDA to CASH FLOW level. The end is what financial gurus coined it “Free Cash Flow”. If you are not happy with the word “Free” seems you know in life, there is no such called “free” then, you might just put “FCF” and you could interpret the first “F” with whatever you want it. Funny Cash Flow, Flowing Cash Flow, Forecast Cash Flow…

I don’t care about what is your interpretation of the FCF, but in essence, it is UNLEVERED CASH FLOW which will determine under a rational and perfect economic environment, the stock prices will be ultimately determined solely by REAL stuffs, in this case, in the MM world, the EARNINGS POWER OF the company’s assets and its investment policy. and NOT by how the the Company got its money to finance it (either by issuing bonds, selling shares, or reinvesting earnings), or even how the fruits of those earnings power are packaged for distributions.

The great thing about MM Theorem, which Professor James Lorie from University of Chicago said jokingly to his students in the 1970s, “is that NOTHING REALLY MATTERS” (quoted from page 82 of the Myth of the Rational Market, by Justin Fox).

This stuck up to my head…nothing really matters.

I tried so hard
And got so far
But in the end
It doesn’t even matter
I had to fall
To lose it all
But in the end
It doesn’t even matter

(Linkin Park)

Super-separating Investment and Financing or Funding is important in building up your Financial Modelling to be more transparent and traceable..and easier to build. The key word : Divide and Conquer! From the Financial Model, the viewer could see clearly which assumptions and key drivers for Investment and which ones for Financing. Financing will only come later after you build the Investment section first. Again, the flow should follow the Waterfall concept. We trace first from where the magic revenue and money will be generated.

So you said, but having unpaid debt is what makes my night restless…..

For that, I don’t have the solution for you.

Though your banker said that debt analysis is very important to factor into the Financial Model or to many valuation modelling, yet the structure of virtually any financial model should follow the ideas of MM in that building a financial model should all start with WHAT THE COMPANY REALLY DOES AND THE FCF AVAILABLE TO THE INVESTORS.

I do hope you got my point. If not, then again, I can’t help you.

#WFH…Work From Home and From Heart!


1 May 2020

*) Note: you might say, geez……..these underlying assumptions are super restrictive and it is not even existent at all in the real world. Yet….I have something to argue back. It is the IMPLICATIONS of the theory that mattered, not the assumptions.

You might think what the implication it was that is so important to make MM awarded with prestigious Nobel.

I tell you what, you might heard this term before, it is called “arbitrage”.

As Marco Pagano put in his Working Paper No. 139 (2005), under the title “The Modigliani-Miller Theorems: A Cornerstone of Finance”:

The second reason for the seminal importance of MM is methodological: by relying on an arbitrage argument, they set a precedent not only within the realm of corporate finance but also (and even more importantly) within that of asset pricing.

In a footnote to its 1958 paper, Modigliani and Miller made references to J.B. Williams (1938), David Durand (1952), and W.A. Morton (1954) as precursors to the first of the M&M propositions. Modigliani distanced his theory from those of the above-mentioned forerunners. He wrote, “None of these writers describe in any detail the mechanism which is supposed to keep the average cost of capital Modigliani and Miller’s (M&M) Hypothesis  constant under changes in capital structure. They seem, however, to be valuing the equilibrating mechanism in terms of switches by investors between stocks and bonds as the yields get out of line with their ‘riskiness.’ This is an argument quite different from the pure arbitrage mechanism underlying our proof, and the difference is crucial.” (quoted from page 110 of the book “Franco Modigliani, A Mind that Never Rests, by Michael Szenberg and Lall Ramrattan. Palgrave MacMillan. 2008)

In the Corporate Finance textbook by Jonathan Berk and Peter DeMarzo from Stanford University (Fourth edition, Pearson, 2017, page 526), the author said MM and the Real World, quoted as follows:

Students often question why Modigliani and Miller’s results are important if, after all, capital markets are not perfect in the real world. While it is true that capital markets are not perfect, all scientific theories begin with a set of idealized assumptions from which conclusions can be drawn. When we apply the theory, we must then evaluate how closely the assumptions hold, and consider the consequences of any important deviations.

As a useful analogy, consider Galileo’s law of falling bodies. Galileo overturned the conventional wisdom by showing that, without friction, free-falling bodies will fall at the same rate independent of their mass. If you test this law, you will likely find it does not hold exactly. The reason, of course, is that unless we are in a vacuum, air friction tends to slow some objects more than others. MM’s results are similar. In practice, we will find that capital structure can have an effect on firm value. But just as Galileo’s law of falling bodies reveals that we must look to air friction, rather than any underlying property of gravity, to explain differences in the speeds of falling objects, MM’s proposition reveals that any effects of capital structure must similarly be due to frictions that exist in capital markets.


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