From getting a brief introduction to get a head-start on building a financial model, then you’re gonna said “What is NEXT”?
I will say, it depends…
Depends on What?
Depends on what models you are going to build, of course.
In practice, there are at least 6 (six) models that we could cover when we are talking about financial model:
- Corporate Model.
- Project Finance Model
- Acquisition or Leveraged Buyout Model
- Merger Model
- Financial Institution Model
- Real Estate Model
Here I would like to touch on Corporate Model vs Project Finance Model.
Cut to the chase, Corporate Model will involve the company that have a history and as like many corporation, they have longer life, and in many cases, the modeler, will build into the assumption, that that company (and business) could last indefinite (Note> INDEFINITE doesn’t have the same meaning as that INFINITE. Please use your online dictionary to find out the big difference of that two terms.)
Since we have assumed away that that company could last into indefinite years, then it will be much efficient, that we reflect that value of indefinite business into one figure, called or termed as Terminal Value. We could put whatever figures we want into this Terminal Value, as long as we can sell this idea to the investor or reader. For example, the question what does that Terminal Value mean?
We might assume:
The Company being sold (or purchased) = Terminal [Cash/Share Swap] Value
The Company being liquidated (or gone into bankruptcy) = Disposal/Scrap Value
The Company being merged with other company = Selling [Share Swap/Non-Cash] Value
The Company being there forever = Continuing Value
The Company being….. = Horizon Value (I put Horizon Value since I don’t know what term I need to put here…, can we put Probable or even Future Value, since we have no idea what will happen in the future? Anything could happen.]
You could add your version yourself, but one thing to bear in mind, that you need to check the ROIC, ROE and ROA figures at that point of “Terminal” year as making economic sense. If they are too high…then it could indicate that that year should not be the “terminal” year. How long and how low can it go, then? Some finance scholars and practitioners might say that that ROIC might be not too far to cost of capital in the long-run. Is this correct? What do you think?
Check as well the working capital growth and the capital expenditures level at that point of “terminal value”. Again, remember the adage saying that it takes MONEY to make MONEY. So it will certainly take certain level for the working capital and capex level to sustain high valuation at Terminal Value.
If you believe in the Myron J. Gordon Growth formula for calculating Terminal Value = FCF_t (1+g)/(WACC-g), then be noted, that we could have a wide range of terminal value, just by changing the growth rate (g) and the WACC (cost of capital), two variables that are the most difficult to assess in many valuations, terminal growth rate and terminal cost of capital.
When setting the terminal growth rate, instead of focusing on how much we want to put the % for that rate, I guess, the more important to think is, what spurs that rate. High terminal growth rate will for sure require more capital expenditures to invest in that later years. How much is the growth rate for the capex? You should remember, that it takes Money (and some moderate grain of risk) to make Money. Without this engine, the “imaginary” high growth rate will come to a screetching halt.
Ok, we go back: it means we need a (detailed) forecast of EBITDA and then Cash Flows for the indefinite life of the company.
The key outputs of this Corporate Model is Earnings per Share (EPS), Return on Investments (ROI), and don’t forget your shareholders, which means we need as well ROE (Return on Equity). Making Shareholder’s happy should be your first and foremost goal! They love it when you put something about the measurement of the performance of the management of the company…..but they will be happier if you remember their money being invested into that company, and this will drag you to put ROE always in your model. The shareholders want to know whether their money invested will return return (2 Returns) that high enough to justify finance sense to put their money in that corporation business, compared to being put in the other investments, such as deposit, stock, bonds, etc. (equivalent investment with comparable risk and period.)
Corporate Model indicates explicitly that the search is for the Shareholder Value, which view is ubiquitous in many corporate finance textbook, and its term was first coming from Alfred Rappaport, a business school professor. However, as a side note, in 2019, 181 US Top CEOs signed a one-page declaration, which that ended as follows: “Each of our stakeholders is essential. We commit to deliver value to all of them, for the future success of our companies, our communities and our country.” (https://hbr.org/2019/08/181-top-ceos-have-realized-companies-need-a-purpose-beyond-profit). The idea about 3Ps, Profit, People and Planet, or also know as “Triple Bottom Line” has increasingly been getting into the mainstream.
What do you think about Triple Bottom Line? Or is it Impossibility Trinity? Feel free to share your opinion.
However, for the time being, the Corporate Model will talk only the first P, that is Profit. And……it is a general’s command: return cash (dividends) to shareholders when there are no credible value-creating opportunities to invest in the business, earning return higher than its costs. This general’s command is something that we should put at the back of the mind even though the Corporate Model itself will drive the dividends modelling using sort of dividend payout ratio or policy (which again, this is a discretionary decision).
Another thing that I would like to mention is Return on Investment (ROI). Though this ROI sounds very familiar to many people, even from their university time, yet in practice, the way ROI is defined, might be quite different. I found there are so many abbreviations for such way to measure the productivity of capital, to relate profit to invested capital, or cash flow to spending, and to quantify the rate of return earned before or after getting the investors’ money back.
ROIC = Return on “all” Invested Capital,
ROCE = Return on Capital Employed vs Return on Common Shareholders’ Equity
RONIC = Return on New or Incremental Invested Capital
ROA = Return on Assets (and RONA = Return on “Net” Assets or ROC = Return on Capital)
Generally speaking, the rate of return on capital employed (interest-bearing debt + common shareholders’ equity falls between ROA and ROE)
And the most confusing is the way that for what we put for the numerator and denominator to calculate all the above. For numerator, some put net income, net income before interest expense (net of tax savings) on long-debt, etc. etc.
If you ask my suggestion, if you found such ROI, etc above, the very question you need to look at : ASKING and CHECKING how that ratio is calculated. Moreover, CONSISTENCY in calculation is crucial as well. For example, if we compare Net Income to total Debt and Equity, then I don’t think this is correct. Logically, net income is the residual income after the interest expense is deducted, and then this should only relate to Equity and not to the sum of total Debt and total Equity.
Another people, instead of using end-of-month or end-of-year balance for Investment, Debt or Equity, will use the average of two period ends. I have no idea which one is correct.
I can’t say which one is correct from all above calculation for ROI. Each author have his/her own argument to defend : McKinsey, finance professor, finance practitioners.
Again, CHECK and always put your feet on the ground. If the number seems too good to be true, then it might be that so. Meaning it is not true.
If you feel the way is calculated, make you confused, probably that’s the intention. Albert Einstein once said:
“If You Can’t Explain it to a Six Year Old, You Don’t Understand it Yourself”
My tip, if you see somebody gave you ROI, then back asking him/her, which one you are talking about, left-hand of the balance sheet or right-hand of the balance sheet, as depicted below:
Source: Corporate Finance : Theory and Practice by Pascal Quiry, Maurizio Dallocchio, Yann Le Fur and Antonio Salvi. Fifth Edition. 2018. Page 46.
If he/she can’t really tell you..then better to leave him/her.
Pls keep in mind that:
- ROA measures the profitability of operations before considering the effects of financing. It will make sense to use ROA if what we are interested in, is the profitability and the efficiency of the firm’s core operations or its operating assets.
- When somebody is talking about Returns (since Returns matters!) or cash flows, then you need to ask first, returns to whom? To the Firm or to the Capital providers? There is a big difference between this. For example, when we read the Statement of Cash Flows of the Company, then that’s the net cash flowing into or out of the Company.
How about ROE, which is one single ratio that represents the shareholder’s wallet. Well, as the manager of the company, then it is one of his/her job to maximize this ROE, in other words, to maximize the shareholder’s [market] value in the company.
My caveat to you, don’t be too impressed on ROE.
One of many issues with ROE, is in ROE, we can’t find risk element. Again, as you probably already new, RETURNS and RISKS is two sides of the SAME COIN. Under Modern Portfolio Theory, the shareholders do not only concern or care about the RETURNS but also, of course, the RISK.
Another shortcomings, in ROE, we don’t see the second crucial element to consider in all investment performance, that is the SIZE of the investments. In another color, how much money is invested by the shareholders to earn that ROE. Higher ROE, let’s say 50% of US$ 1 mio versus Lower ROE of 25% of US$ 10 mio: Which one you are going to pick up?
Shareholder’s [market] value will always involve the talk about the RETURN, the RISK and the SIZE of the “skin in the game” (read: money put on the table).
G. Bennett Stewart, III in his book “Best-Practice EVA: The Definitive Guide to Measuring and Maximizing Shareholder Value” (John Wiley & Sons, 2013), wrote (p. 86) about what’s wrong with RONA (= ROE)?
RONA and the other conventional return metrics are highly misleading and incomplete performance indicators, for reasons I will explain. And the deficiencies are far from academic. As you will see, companies that have aimed to increase RONA or maintain a high RONA have committed major blunders in strategy and resource allocation. And when RONA is judged
from the bird’s-eye view of how well it performs as an element in a firm’s. overall management system, it fails, or at least it is far inferior to EVA, as I have been saying and will continue to elaborate.
RONA fundamentally fails because it is inconsistent with what is—or should be—the main mission of every firm, which is to maximize the wealth of its owners. It is to maximize the difference between the capital that investors have put or left in the business and the present value of the cash flow that can be taken out of it. In short, the goal is to maximize MVA by maximizing the stream of EVA, as I have said.
Here’s the problem in a nutshell. RONA tells us about the ratio of market value to invested capital, but that is not the same thing as maximizing the spread between market value and invested capital, which is the true goal. A company that aims to maximize RONA will always tend to hold back and underinvest, underinnovate, underscale, and undergrow. It will leave value
and growth on the table, and become vulnerable to a hostile takeover or a toppling by upstart rivals.
I gather that now you are more skeptical about reading high or low ROE.
We can’t buy something using high or low ratio. Instead, it is the difference or the gap between the amount you invested and the amount you get back!
I gather, now we keep going.
Then, we move talking about Project Finance Model.
You said, the finance books that I had back in my finance class, all have title “Principles/Fundamentals/Essentials of Corporate Finance” or “Managerial Finance”, none of them have a title of Project Finance.
I hope you still remember that one of the chapters or sections in many Corporate Finance textbooks, they are talking about Capital Budgeting technique and how to apply that. Some techniques, such as IRR is useful when the model we build is about Project Finance Model.
The Project Finance model is being used to evaluate a project or investment that :
- have no history of cash flows at all
- the project have lifetime (like a human, there is a birth date and death date)
As a background for the popularity of Project Finance model, is, in many developing countries, government partners with private sectors to build infrastructures such as roads, hospitals, power plants, etc. Most of those projects are analyzed or financial-model built on project finance concepts.
We can’t bring corporate finance concept into project finance model, since the creditors cannot stand on assets-in-place (since there is no historical balance sheet at all to stand on) to seek remedy. And the risk is so big, considering no history of cash flows at all and no historical balance sheet to stand on in case the project fails), then risk sharing is the key to this project success.
Accordingly, the project finance model should focus on two things:
(i) Cash flows flowing to lenders
(ii) Cash flows flowing to equity holders and/or sponsors
Those two cash flows are so important to model, as all cash flows generated by the project itself during the entire lifetime of the project will ALL distributed to lenders, equity holders, sponsors, and not be re-invested to the company (the latter is for Corporate Model). Accordingly, key outputs of Project Finance model will be the Project IRR (pre and post tax), and Equity IRR. Again, the latter is to let the shareholders know that you are thinking about their pocket ultimately.
a) If there is pre-tax IRR in the Project Finance model, how about in the Corporate Model? Do we have pre-tax ROI?
Answer: Pre-tax ROI? What I could say, the ratio of EBITDA to Investment (net working capital and net fixed assets) could represent pre-tax ROI. Though this might raise a bit question, since EBITDA is computed BEFORE DEPRECIATION, and when it comes to “Return”, it should be calculated AFTER DEPRECIATION. Nonetheless, EBITDA/Net Investment is commonly being used in the assessment of the Corporate Model.
b) Why do we need to come up with Pre-Tax IRR in the Project Finance model? How about if the resulting Pre-Tax IRR is lower than the market interest rate? How about if the resulting Pre-tax IRR looks higher than the cost of capital? What does it implicate something to you?
Prof. Peter DeMarzo’s comment:
Yes, the lack of collateral can diminish the opportunity for credit. But indeed, this is not so different from many projects in the corporate sector, if the main assets are in the form of human capital. From the perspective of the cost of capital, again the main driver should be the beta of the project cash flows. An additional risk may be that of expropriation, which is more likely in bad times. This expropriation risk would raise the beta. What other factors do you see?
I believe many project finance assets are not in the human capital. One of the common characterictic of many project finance, they are marked with low tech risks and mostly dealing with predictable market, so having heavy project physical assets still make reasonable finance sense.
About project risks..beta I don’ t think it could reflect all risks being involved in project finance. As I put before, project finance doesn’t depend on soundness and profitability of the company. Mostly will deal with totally new venture. So the soundness and profitability of the venture itself is the main critical factors.
Project finance in most cases will involve very large scale to the company’s current size, sheer higher risk compared to “average” risk that beta could capture, and have potential contamination risk. In view of these risks, project finance will carefully identify the risk during each phase of the project, such as during development phase, construction, completion, operations and maintenance, etc, then allocate that respective risk to the party that could handle that risk the most efficient and effective. This is why we see so many parties being parts to the Project Finance agreement.
This all brings to ascertain the project has low supply risk, low commercial risk as all output will be taken by a single offtaker or a few large buyer or products being consumed by general public, secured long-term concession (sometimes plus monopoly right being awarded), etc.
One classic paper to read is written by Brealey, Cooper and Habib “Using project finance to fund infrastructure investments” Journal of Applied Finance 9 (1996).
Project Finance in many fronts are quite different from Corporate Model, for example, there are different phases over the life of the a project (remember, a project have a date of birth and date of death), they are:
- development phase
- construction phase
- operation phase
- debt repayment phase
- debt refinancing phase
The aforementioned different phases will involve different risks to handle, and WHEN THE RISKS CHANGES, THEN THE VALUE WILL CHANGE AS WELL.
From the eyes of the equity contributor, then he key output of Project Finance is Internal Rate of Returns to equity holders, which will mean that this IRR will be calculated from the project cash flows AFTER all debts and its interest have been serviced and paid to the debtholders. Which mean, at the end of the day, all cash flows generated by the project will flow to the last penny to all the contributors to the projects. Since IRR to equity holders are coming AFTER the debt servicing, then this resulting figure (good or bad, or as expected) will be flowing from the PROFIT AND LOSS PERFORMANCE (summarized in the Profit and Loss Statement), then CASH FLOW STATEMENT. Modelling through all these statements, the modeler could see that the following factors will play a role in determining the equity IRR for Project Finance model:
- the financing size. This first factor is not quite surprising knowing that all project finance is all about funding big fat question, that is how to finance such sizeable project.
- Once the financing size is answered, then it comes to ABC and the loan tenor. What is ABC? ABC is talking about the Debt repayment, how the project will pay back the loan : “A” Amortising Debt, “B” Bullet Repayment of Debt, and “C” Loan with Interest Capitalized. Here is about the TIMING of the repayment of the debt. Bullet Repayment as it puts there “Bullet”, it means the debt will be paid in one time at the end of the debt term or tenor (this is why possibly the term is called “Bullet” = Bullet to the Head if you don’t pay!), or the pattern of debt principal repayment is akin to the bullet form, so some portion of the debt amount is paid along the duration of the loan.
As you probably know that IRR magnitude is very sensitive to (i) the pattern of the cash flows and (ii) the duration of the project cash flows. This is why IRR is called “INTERNAL”, the calculation of IRR doesn’t need external elements, all it needs is just the CASH FLOWS and the TERM of the Cash Flows. We don’t need even the Discount Rate or COST OF CAPITAL (from market).
You might say, oke, you’re covering the equity IRR. How about the debt contributor? They might take risk as well in the project.
From the perspective of the debt contributor, then the big fat question is always, whether:
- Can I get back my debt principal (Return OF debt)?
- Can I get back my debt interest (Return ON debt)?
So the lender in this case will be quite prudent to see whether the project cash flow has sufficient BUFFER ABOVE the debt service obligations, and here, we are talking about DEBT SERVICE COVERAGE RATIO. You might call this “Margin of Safety”. The higher the DSCR, the more MOS that the lender have. DSCR = 1 will mean that all project cash flows are gone to service the debt and the interest. However, this is not prudent in case there is A SHOCK to the project cash flows, which means that the lender won’t get its repayment as scheduled.
The other factor that the lender would see is comparing the tenor of the debt vs the life of the project. If the project life is longer than debt tenor and could still generate cash flows, even after the forecasted debt repayment, then it means, the lender could have another MOS, in case the scheduled repayments do not happen as forecasted, and needs to come back to the project owner to negotiate for restructuring the loan. Here is called “Cash Flow Tail“. The longer the Cash Flow Tail period, then it is much better for the lender.
Some authors have outlined the difference between Corporate Financing and Project Financing as depicted below.
Source: https://youssef-serghini.weebly.com/project-finance-vs-corporate-finance.html (accessed on 31 May 2020)
Source: Project Finance in Theory and Practice : Designing, Structuring, and Financing Private and Public Projects (2nd edition) by Stefano Gatti. Page 4. 2013. Elsevier Inc.
However, I come to the point that Corporate Finance and Project Finance is an overlapped concept. Project Finance in its far end, like all those big infrastructure and energy projects, they are developing to different world on its own, so it is easy to forget that the concept is coming or shared the same way as that Corporate Finance in many aspects. Project Finance origin should be part of Corporate Finance, (as discussed originally in the capital budgeting sections of many books), but when that projects share no same characteristics as that the average projects that the company has run before, in terms of returns, risk, phase, etc…then this needs parties and partners to share the risk and return, I guess, this is where all the Project Finance books and training try to show us. Sharing risk and return is not something that we discuss at length under Corporate Finance, since the focus is on maximizing the shareholders’ value. Under Project Finance, we don’t always put too much emphasis on MAX shareholders’ value, though we use all the capital project evaluation concepts from CF, such as IRR, NPV, etc.
Respondent to Karnen (10 June 2020):
Corporations are portfolios of projects and the ultimate ROIC should be the aggregate of project IRR’s (with big problems of reinvestment etc.). Similarly the ROE should correspond to equity IRR’s.